Public Policy – Page 72 – The Aleph Blog

Uncharted Waters

Posted on 22 December 200922 December 2009 by David Merkel

It does not matter how you measure it, the US Treasury yield curve is at its steepest level ever.? Away from that, the value for expected five-year inflation, five years from now is at its highest level ever, excluding the noise that we had as our markets crashed in the fourth quarter of 2008.

This concerns me.? Anytime we hit new extremes on critical financial variables, it makes me think, “What next?”? Treasury yield curve slope and inflation expectations are fundamental.? Reaching unprecedented levels is a big thing.

Could the US Government ever face the possibility that it could not meet its obligations?? I think so, and a record wide yield curve is one of the things that I would see prior to such troubles.

Last week, I had dinner with my friend Cody Willard.? His favorite idea was shorting long bonds.? I indicated that I had some leaning that way but could not go? all the way on that idea, as the Federal Reserve had the option of inflating during the Great Depression, and did not do so.? Cody said something to the effect of “but we have so much less flexibility today.”? Can’t argue with that, though I wonder whether politicians and bureaucrats favor foreign claims over domestic claims.? Would they bankrupt Americans to pay off foreign claimants?? Yes, they might do that.? It has happened before.

Cody might be on the right track, but the steepness of the yield curve may fight him.? It is very, very hard to get a yield super-steep without something breaking — inflation running rampant, etc.

The greater worry from my angle is the US pursuing Japanese solutions that have failed miserably over the past 20 years.? Japan continues to follow failed Keynesian ideas, fostering a low return on asset culture, with all of the failed projects financed by very low interest rates.? Now we do the same.? The Fed runs a low interest rate policy via Fed Funds and buying mortgage bonds.

All that does is reinforce mediocrity by enabling assets with low returns to be financed and survive.? Better that many of those should die, and the capital be released to more profitable uses.

All of this is the price for not allowing recessions to be deep — now we have to clear away bad loans bigtime.? But who has the courage to do that?? Certainly not our government.? They avoid all short-term pain, leading to long-term problems.

That’s where we are now, in uncharted economic waters.

Tribune and AIG — Two Debacles

Posted on 20 December 200920 December 2009 by David Merkel

I never thought the deal where Sam Zell bought Tribune was fair, because it relied on the savings of workers in their ESOP [employee stock ownership plan].? Here is what I wrote in the past:

Well, now Mr. Zell is getting sued by Tribune employees, and he deserves it.? Zell could not have bought out Tribune without the support of the ESOP, but his actions harmed the economic interests of the ESOP, and thus the employees.? Many will agree to anything if their job is threatened.? The semi-coercion plus failure will not work out well for Mr. Zell.

-=-==–==–==–==-=–=-==-=-=-=-=–=-=-=

And, speaking of not working out well, we have the NYT Op-ed on AIG.? I say good, let AIG, the Fed and the Treasury disclose what they said during the bailout.? We already know that many areas of AIG would have gone under without the bailout.? Though the Treasury Secretary has changed his tune on why AIG was bailed out, originally it was only and ostensibly for AIGFP, the derivatives subsidiary.

Let AIG and the Government reveal what they said? regarding the bailout.? The American people deserve to know it.

Catching up on Blog Comments

Posted on 18 December 2009 by David Merkel

Before I start, I would like to toss out the idea of an Aleph Blog Lunch to be hosted sometime in January 2010 @ 1PM, somewhere between DC and Baltimore.? Everyone pays for their own lunch, but I would bring along the review copies of many of the books that I have reviewed for attendees to take home, first come, first served.? Maybe Eddy at Crossing Wall Street would like to join in, or Accrued Interest. If you are an active economic/financial blogger in the DC/Baltimore Area, who knows, maybe we could have a panel discussion, or something else.?? Just tossing out the idea, but if you think you would like to come, send me an e-mail.

Onto the comments.? I try to keep up with comments and e-mails, but I am forever falling behind.? Here is a sampling of comments that I wanted to give responses on.? Sorry if I did not pick yours.

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=–==-=–==-

Blog comments are in italics, my comments are in regular type.

http://alephblog.com/2009/12/16/notes-on-fed-policy-and-financial-regulation/#comments

Spot on David. I often think about the path of the exits strategy the fed may take. In order, how may it look? What comes first what comes last? Clearly this world is addicted to guarantees on everything, zirp, and fed QE policy which is building a very dangerous US dollar carry trade.

Back to the original point, I would think the order of exit may look something like:

1. First they will slowly remove emergency credit facilities, starting with those of least interest, which were aggressively used to curb the debt deflationary crisis on our banking system. The added liquidity kept our system afloat and avoided systemic collapse that would have brought a much more painful shock to the global financial system. Lehman Brothers was a mini-atom bomb test that showed the fed and gov?t would could happen ? seeing that result all but solidified the ?too big to fail? mantra.

2. Second, they will be forced to raise rates ? that?s right folks, 0% ? 0.25% fed funds rates is getting closer and closer to being a hindsight policy. However, I still think rates stay low until early 2010 or unemployment proves to be stabilizing. As rates rise, watch gold for a move up on perceived future inflationary pressures.

3. Third, they can sell securities to primary dealers via POMO at the NY Fed, thereby draining liquidity from excess reserves. I think this will be a solid part of their exit strategy down the road ? perhaps later in 2010 or early 2011. As of now, some $760Bln is being hoarded in excess reserves by depository institutions. That number will likely come way down once this process starts. The question is, will banks rush to lend money that was hoarded rather then be drained of freshly minted dollars from the debt monetization experiment. For now, this money is being hoarded to absorb future loan losses, cushion capital ratios and take advantage of the fed?s paid interest on excess reserves ? the banks choose to hoard rather then aggressively lend to a deteriorating quality of consumer/business amid a rising unemployment environment. This is a good move by the banks as the political cries for more lending grow louder. The last thing we need is for banks to willy-nilly lend to struggling borrowers that will only prolong the pain by later on.

4. And finally, as a final and more aggressive measure, we could see capital or reserve requirements tightened on banks to hold back aggressive lending that may cause inflationary pressures and money velocity to surge. Right now, banks must retain 10% of deposits as reserves and maintain capital ratios set by regulators. Either can be tweaked to curb lending and prevent $700bln+ from entering the economy and being multiplied by our fractional reserve system.

I think we are starting to see #1 now, in some form, and will start to see the rest around the middle of 2010 and into 2011. The last item might not come until end of 2011 or even 2012 when economy is proven to be on right track and unemployment is clearly declining as companies rehire.

Thoughts????

UD, I think you have the Fed’s Order of Battle right.? The questions will come from:

1) how much of the quantitative easing can be withdrawn without negatively affecting banks, or mortgage yields.

2) How much they can raise Fed Funds without something blowing up.? Bank profits have become very reliant on low short term funding.? I wonder who else relies on short-term finance to hold speculative positions today?

3) Finance reform to me would include bank capital reform, including changes to reflect securitization and derivatives, both of which should require capital at least as great as doing the equivalent transaction through non-derivative instruments.

http://alephblog.com/2009/12/15/book-reviews-of-two-very-different-books/#comments

David,
A few years back you mentioned to me in an e-mail that Fabozzi was a good source for understanding bonds (thank you for that advice by the way, he is a very accessible author for what can be very complex material.)? In the review of Domash’s book you mention that he does not do a good job with financials. I was wondering, is there an author who is as accessible and clear as Fabozzi, when it comes to financials, who you would recommend.

Regards,
TDL

TDL, no, I have not run across a good book for analyzing financial stocks.? Most of the specialist shops like KBW, Sandler O?Neill and Hovde have their own proprietary ways of analyzing financials.? I have summarized the main ideas in this article here.

http://alephblog.com/2007/04/28/why-financial-stocks-are-harder-to-analyze/

http://alephblog.com/2009/12/05/the-return-of-my-money-not-the-return-on-my-money/#comments

Sorry to be a bit late to this post, but I really like this thread (bond investing with particular regard to sovereign risk). One thing I’m trying to figure out is the set of tools an individual investor needs to invest in bonds globally. In comparison to the US equities market, for which there are countless platforms, data feeds, blogs, etc., I am having trouble finding good sources of analysis, pricing, and access to product for international bonds, so here is my vote for a primer on selecting, pricing, and purchasing international bonds.

K1, there aren?t many choices to the average investor, which I why I have a post in the works on foreign and global bond funds.? There aren?t a lot of good choices that are cheap.? It is expensive to diversify out of the US dollar and maintain significant liquidity.

A couple of suggested topics that I think you could do a job with:? 1) Quantitative view of how to evaluate closed end funds trading at a discount to NAV with a given NAV and discount history, fee/cost structure, and dividend history;?? 2) How to evaluate the fundamentals of the return of capital distributions from MLPs – e.g. what fraction of them is true dividend and what fraction is true return of capital and how should one arrive at a reasonable profile of the future to put a DCF value on it?

Josh, I think I can do #1, but I don?t understand enough about #2.? I?m adding #1 to my list.

http://alephblog.com/2009/12/05/book-review-the-ten-roads-to-riches/#comments

I see that Fisher’s list reveals his blind spot–how about being born the child of wealthy parents. . .

BWDIK, Fisher is talking about ?roads? to riches.? None of us can get on that ?road? unless a wealthy person decided to adopt one of us.? And, that is his road #3, attach yourself to a wealthy person and do his bidding.

I am not a Ken Fisher fan, but I am a David merkel fan—so what was the advice he gave you in 2000?

Jay, what he told me was to throw away all of my models, including the CFA Syllabus, and strike out on my own, analyzing companies in ways that other people do not.? Find my competitive advantage and pursue it.

That led me to analyzing industries first, buying quality companies in industries in a cyclical slump, and the rest of my eight rules.

http://alephblog.com/2009/11/28/the-right-reform-for-the-fed/#comments

“The Fed has been anything but independent.? An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.”

This seems completely wrong to me.? First, the Fed’s mandate is not to preserve the value of the dollar, but to “”to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”? I don’t see that bailouts are antithetical to those goals. Second, I don’t see how the Fed’s actions in 2008-2009 have particularly hurt the value of the dollar, at least not in terms of purchasing power.? Perhaps they will in the future, but it is a bit early to assert that, I think.

Matt, even in their mandates for full employment and stable prices, the Fed should have no mandate to do bailouts, and sacrifice the credit of the nation for special interests.? No one should have special privileges, whether the seeming effect of purchasing power has diminished or not.? It is monetary and credit inflation, even if it does not result in price inflation.

?Make the Fed tighten policy when Debt/GDP goes above 200%.? We?re over 350% on that ratio now.? We need to save to bring down debt.?

David, I fully agree (as with your other points).
However, I do not see it happening.

Why would we save when others electronically ?print? money to buy our debt?

See todays Bloomberg News:
?Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.?

Please note that last year the amount auctioned was much lower (so foreign central banks bought a much lower percentage of a much lower total).

Please also note that all of a sudden, earlier this year, the definition of ?indirect bidders? was changed, making it more complicated to follow this stuff. What is clear however, is that almost half of the incredible amount of $ 2 trillion, i.e. $ 1000 billion (!!), is being ?purchased? by the printing presses of foreign central banks.

This could explain both the record amount of debt issued and the record low yields.

As the CBO has projected huge deficits PLUS huge debt roll-overs (average maturity down from 7 years to 4 years) up to at least 2019, do you think we could extend the ?printing? by foreign central banks? — CB?s ?buying? each others debt — for at least 10 more years?
That would free us from saving, enabling us to ?consume? our way to reflation of the economy (as is FEDs/Treasuries attempt imo).

I?d appreciate your, and other readers?, take on this.

Carol, you are right.? I don?t see a limitation on Debt to GDP happening.

As to nations rolling over each other?s debts for 10 more years, I find that unlikely.? There will be a reason at some point to game the system on the part of those that are worst off on a cash flow basis to default.

The rollover problem for the US Treasury will get pretty severe by the mid-2010s.

http://alephblog.com/2009/11/13/the-forever-fund/#comments

Any chance of you doing portfolio updates going forward? I?d be curious to see if you still like investment grade fixed incomes, given the rally.

Matt, I would be underweighting investment grade and high yield credit at present.

As for railroads, I own Canadian National ? unlike US railroads, it goes coast to coast, and slowly they are picking up more business in the US as well.

Long CNI

http://alephblog.com/2009/11/10/my-visit-to-the-us-treasury-part-7-final/#comments

Did none of the bloggers raise the question of the GSEs? I can understand Treasury not wishing to tip their hands as to their future, but I would have expected their status to be a hot topic among the bloggers.

I also don?t buy the idea that the sufferings of the middle class were inevitable. Over the past 15 or so years the financial sector has grown due to the vast amount of money that it has been able to extract. Where would we be if all of those bright hard working people and capital spending had gone to the real economy? I?m not suggesting a command economy, but senior policymakers decided to let leverage and risk run to dangerous levels. Your comment seem to indicate that this was simply the landscape of the world, but it seems more to be the product of a deliberate policy from the Federal government.

Chris, no, nothing on the GSEs.? There was a lot to talk about, and little time.

I believe there have been policy errors made by our government ? one the biggest being favoring debt finance over equity finance, but most bad policies of our government stem from a short-sighted culture that elects those that govern us.? That same short-sightedness has helped make us less competitive as a nation versus the rest of the world.? We rob the future to fund the present.

http://alephblog.com/2009/11/07/my-visit-to-the-us-treasury-part-6/#comments

it?s not clear from your writing whether the treasury officials talked to you about the GSEs or whether your comments (in the paragraph beginning with ?When I look at the bailouts,?) are your own. could you clarify?

q, That is my view of how the Treasury seems to be using the GSEs, based on what they are doing, not what they have said.

http://alephblog.com/2009/10/31/book-review-nerds-on-wall-street/

?There are a lot of losses to be taken by those who think they have discovered a statistical regularity in the financial markets.?
David, take a look at equilcurrency.com.

Jesse, I looked at it, it seems rather fanciful.

http://alephblog.com/2009/10/27/book-review-the-predictioneers-game/#comments

David,
Just wondering if there?s an omission in this line:

?The last will pay for the book on its own. I have used the technique twice before, and it works. That said, that I have used it twice before means it is not unique to the author.?

Did you mean to write ?that I have used it doesn?t mean it is not unique?.?

In the event it is, I?ll look it up in the book, which I intend to buy anyway.
Otherwise, may I request a post that details, a la your used car post,your approach to buying new cars?

Saloner, no omission.? I said what I meant.? I?ll try to put together a post on new car purchases.

http://alephblog.com/2009/10/22/book-review-the-bogleheads-guide-to-retirement-planning/

thanks for the book review. it sounds like something that i could use to get the conversation started with my wife as she is generally smart but has little tolerance for this sort of thing.

> unhedged foreign bonds are a core part of asset allocation

i agree in principle ? it would be really helpful though to have a roadmap for this. how can i know what is what?

I second that request for help in accessing unhedged foreign bonds ? Maybe a post topic?

JK, q, I?ll try to get a post out on this.

http://alephblog.com/2009/10/20/toward-a-new-theory-of-the-cost-of-equity-capital-part-2/#comments

to the point above, basically just an IRR right?

JRH, I don?t think it is the IRR.? The IRR is a measure of the return off of the assets, not a rate for the discount of the asset cash flows.

When I was an undergraduate (after already having been in business for a long time), I realized that M-M was erroneous, because of all the things they CP?d (ceteris paribus) away. For my own consumption, I went a long way to demonstrating that quantitatively, but children, work and family intervened, and who was I to argue with Nobel winners.

But time, experience and events convince me that I was right then and you are right now. As you?ve noted the market does not price risk well. In large part this is due to a fundamental misunderstanding of value. The professional appraisal community has a far better handle on this, exemplified by drawing the formal distinction between ?fair market value as a going concern?, ?investment value?, ?fair market value in a orderly liquidation?, ?fair market value in a forced liquidation? and so on. One corollary to the foregoing is one of those lessons that stick from sit-down education, that ?Book Value? is not a standard of value but rather a mathematical identity.

Without going into a long involved academic tome, the cost of capital (and from which results the mathematical determination of value per the income approach) has a shape more approaching that of a an asymmetric parabola (if one graphs return on the y axis and equity debt weight on the x.).

If I was coming up with a new theorem, risk would be an independent variable. So for example:

WAAC = wgt avg cost of equity + wgt avg cost of debt + risk premium

You?ll note the difference that in standard WAAC formulation risk is a component of the both the equity and debt variable ? and practically impossible to consistently and logically quantify. Yes, one can look to Ibbottson for historical risk premia, or leave one to the individual decision making of lenders, butt it complicates and obscures the analysis.

In the formulation above, cost of equity and cost of debt are very straightforward and can be drawn from readily available market metrics. But what does risk look like? Again if you plot risk as a % cost of capital on the y axis and on the x axis the increasing debt weight, on a absolute basis risk is lowest @ 100% equity. From there is upwards slopes. However, risk however is not linear, but rather follows a power law.

The reason risk follows a power law is that while equity is prepared to lose 100%, debt is not. Also, debt weight increases IRR to equity (in the real world) contrary to MM. Again, debt is never priced well, because issuers don?t understand orderly and forced liquidation, whereby in ?orderly?, e.g. say Chapter 11,recoveries may be 80 cents on the dollar, and forced, e.g., Chapter 7, 10 cents on the dollar. One really doesn?t begin to understand the foregoing until you?ve been through it more than a few times.

So in the real world, as debt increases, equity is far more easily ?playing with house money.? A recent poster child for this phenomena is the Simmons Mattress story. In the most recent go round equity was pulling cash out (playing with house money) and the bankers were either (depending on one?s POV) incredibly stupid for letting equity do so, or incredibly smart, because they got their fees and left someone else holding the bag. I?m seen some commentators say that ?Oh it was OK because rates were so low, the debt service (the I component only) was manageable.? Poppycock; sometime it?s the dollar value and sometimes it?s the percentage weight and sometimes it is both.

But you?ve already said that: ?company specific risk is significant and varies a great deal.? I would also add that ? or amplify ? that in any appraisal assignment the first thing that must be set is the appraisal date. Everything drives off that and what is ?known or knowable? at the time.

Gaffer, thanks for your comments.? I appreciate the time and efforts you put into them.? This is an area where finance theory needs to change.

http://alephblog.com/2009/10/10/pension-apprehension/

I have a DB plan with Safeway Stores-UFCW, which I?ve been collecting for a few years. I?m cooked?

Craig, not necessarily.? Ask for the form 5500, and see how underfunded the firm is.? Safeway is a solid firm, in my opinion.

Long SWY

http://alephblog.com/2009/09/29/recent-portfolio-actions/#comments

David, I am curious about your rebalancing threshold. Do you calculate this 20% threshold using a formula like this:

= Target Size / Current Size ? 1

I have a small portfolio of twenty securities. A full position size in the portfolio is 8% (position size would be 1 for an 8% holding). The position size targets are based generally on .25 increments (so a position target of .25 is 2% of the portfolio and there are 12.5 slots ?available?). I used that formula above for a while, but I found that it was biased towards smaller positions.

Instead I began using this formula:

= (Target ? Current Size) / .25

So a .50 sized holding and a full sized holding may have both been 2% below the target (using the first formula), but using the second formula, they would be 8% and 16% below the target respectively. I found this showed me the true deviation from the portfolio target size and put my holdings on an equal footing for rebalancing.

I was curious how you calculated your threshold, or if it was less of an issue because you tended to have full sized positions. For me, I tend to start small and build positions over time. There are certain positions I hold that I know will stay in the .25-.50 range because they either carry more risk, they are funds/ETFs, or they are paired with a similar holding that together give me the weight I want in a particular sector.

Brian, you have my calculations right.? I originally backed into the figure because concentrated funds run with between 16-40 names.? Since I concentrate in industries, I have to run with more names for diversification.? I don?t scale, typically, though occasionally I have double weights, and rarely, triple weights.? The 20% band was borrowed from three asset managers that I admire.? After some thought, I did some work calculating the threshold in my Kelly criterion piece.

A fuller explanation of the rebalancing process is here in my smarter seller pieces.

http://alephblog.com/2009/09/04/tickers-for-the-latest-portfolio-reshaping/

Have you seen DEG instead of SWY?
Extremely able operator. Some currency diversification as well. I?d like to know your thougts.

MLS, I don?t have a strong idea about DEG ? I know that back earlier in the decade, they had their share of execution issues.? It does look cheaper than SWY, though.

Long SWY

http://alephblog.com/2009/06/11/problems-with-constant-compound-interest-2/

I like your post and want to comment on a couple of items.? You point to the peak of the 1980’s inflation rates and the associated interest rates.

Robert Samuelson wrote a book called The Great Inflation and it’s Aftermath.?? http://tiny.cc/z9H9V

Basically you can explain a great deal the US stock market history of the 40 years by the spike in interest/inflation until the mid 80’s and the subsequent decline.? Since you need an interest rate to value any cash flow, the decline in interest rates made all cash flows more valuable.

The thing that is odd and sort of ties this together is the last year.? After interest rates crossed the 4% level things started blowing up.? The amount of debt that can be financed at 3% to 4% is enormous.? That is, as everyone knows, on of the root causes of the housing bubble.? Anyway, starting last year, treasury interest rates continued to decline and all other rates went through the roof.

I was looking at this chart yesterday.? _ http://tiny.cc/eCZzF The interesting thing to me was that when the system blew up, treasury rates continued to decline and all non guaranteed debt rates went through the roof.

Most of this is obvious and everyone knows the reasons.? The one thing that seems novel is thinking of this as the continuation of a very long secular trend — or secular cycle.? I don’t want to get overly political, but the decrease in inflation/interest in the 90’s to the present was a function of productivity/technology and Foreign/Chinese imports.? Anyway, one effect of these policies was a huge rise in asset values, especially in the FIRE (finance, insurance, real estate) sector of the economy at the expense of our industrial and manufacturing sectors.? This was also a redistribution of wealth from the rust belt to the coasts.

It is much more complicated then the hand full of influences I mentioned, but the one thing i haven’t seen discussed a lot is the connection of the current catastrophe to the long term decline in inflation/interest rates since the mid/late 1980’s.? If you think about it, declining interest rates increase the value of financial assets and are an enormous tailwind for finance.? I suppose if you had just looked at the curve, it would have been obvious that the trend couldn’t continue.? Prior to the blowup, there were lots of people financing long term assets with short term, low interest rate liabilities. That was a big part of the basic playbook for structured finance, hedge funds, etc.

The reason that the yield spread exploded is well known.? Here is a snippet from Irving Fisher.? http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html

CapVandal ? Great comment.? A lot to learn from here.? I hope you come back to blogging; you have some good things to say.? Fear and greed drive correlated human behavior.

Redacted Version of the December FOMC Statement

Posted on 17 December 200917 December 2009 by David Merkel

November 2009	December 2009	Comments
Information received since the Federal Open Market Committee met in September suggests that economic activity has continued to pick up.	Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating.	They think that the labor market is getting worse but at a very slow rate.
Activity in the housing sector has increased over recent months.	The housing sector has shown some signs of improvement over recent months.	No real change.
Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.	Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit.	Shading up income growth, shading down unemployment.
Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.	Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales.	More shading unemployment downward.

———————————————————————————————————

Conditions in financial markets were roughly unchanged, on balance, over the intermeeting period.	Financial market conditions have become more supportive of economic growth.	Sentence moved from higher up in the statement. More optimistic.
Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.	No real change.
With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.	No change.
In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.		A useless sentence eliminated.
The Committee will maintain the target range for the federal funds rate at 0 to ? percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Committee will maintain the target range for the federal funds rate at 0 to ? percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	This gives you the trigger for when they will raise the Fed Funds rate. As I said last month, watch capacity utilization, unemployment, inflation trends, and inflation expectations.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of$1.25?trillion of agency mortgage-backed securities and up to $200 billion of agency debt.	To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve is in the process of purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt.	No real change. We knew this from prior announcements.
The Committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010.		Sentence no longer needed.

—————————————————————————————————

	In light of ongoing improvements in the functioning of financial markets, the Committee and the Board of Governors anticipate that most of the Federal Reserve?s special liquidity facilities will expire on February 1, 2010, consistent with the Federal Reserve?s announcement of June 25, 2009. These facilities include the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility. The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1. The Federal Reserve expects that amounts provided under the Term Auction Facility will continue to be scaled back in early 2010. The anticipated expiration dates for the Term Asset-Backed Securities Loan Facility remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral.	New sentence. This was well-disclosed in advance. That part of the Fed balance sheet has been shrinking for some time. The real elephant is what the Fed does with the MBS.
As previously announced, the Federal Reserve?s purchases of $300?billion of Treasury securities will be completed by the end of October 2009.		Treasury program is done.
The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.		A useless sentence eliminated.
The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.	The Federal Reserve is prepared to modify these plans if necessary to support financial stability and economic growth.	No real change. Another useless sentence.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.	No change.

Comments

The FOMC sees unemployment and GDP growth improving in the near term.? I would not be so sure.
Ignore the long new sentence about the liquidity programs going away.? We knew that was coming.? The critical issue at present is what the Fed will do with all of the MBS it owns.? There is no easy way to shrink that without affecting the long end of the yield curve negatively.
The Fed is more optimistic about the financial markets, but I am not sure why.
As I said last month, the trigger for when the Fed will raise the Fed Funds rate is this:
- watch capacity utilization
- unemployment
- inflation trends
- inflation expectations.

Notes on Fed Policy and Financial Regulation

Posted on 16 December 2009 by David Merkel

I’m not likely to be able to comment when the FOMC announces its lack of action today.? The Fed will continue to keep policy loose, while slowly closing down ancillary lending programs, and bloating their balance sheet with mortgage backed securities [MBS] guaranteed by Fannie and Freddie, and ultimately by the Federal Government, which gets the profit or loss from the Fed’s financing (of the mortgages at 0% interest for now).

Going back to last night’s post, strip away the complexity, and what you have is the Federal Government intervening in the MBS market, and forcing down yields, at a cost of indebting future generations (should they decide to make good on those).? This will eventually fail as a strategy.? Unless the Fed wants to keep its balance sheet permanently larger, yields on MBS will rise when they stop buying.? And, the moment that they hint that they will start unloading, rates will back up significantly.? They are too large relative to the MBS market.

They can engage in fancy strategies where they try to remove policy accommodation either through rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn’t know what will happen when a tightening cycle starts, but usually it ends with a bang — some market blowing up.

Two more notes: it doesn’t matter who the Fed Chairman is.? The structure of the Fed matters more than the man.? That said, Bernanke has promised transparency but has not given it at the most crucial times — those dealing with the bailouts.? All of the talk to audit/limit/shrink/end the Fed comes from abuse of those powers, which should be done by the Treasury and Congress, so that voters can hold them accountable.

Finally, one quick note on regulation of financials.? Laws don’t mean squat if regulators won’t enforce them.? There was enough power in prior laws for regulators to have curbed all of the abuses.? The regulators did not use their powers then; what makes us think that they will use expanded powers?? Regulatory capture has happened in the banking industry; regulators will have to get ugly with those that they regulate if they genuinely want to regulate.

This includes changing risk-based capital formulas to remove the advantage of securitizing debt.? I’m not saying penalize securitization, but put it on a level playing field so that the inherent leverage involved in securitization gets a higher capital charge relative to straight debt of a similar risk class.

That also includes not letting banks fudge asset values to give the appearance of solvency, but more on that tonight.? I gotta fly now on business.

Handing Over Goods for Promises

Posted on 16 December 2009 by David Merkel

Twenty years ago, I hit upon the idea that I should analyze entitlement programs by assuming that the dividing wall between the trust funds and the government did not exist.? That’s a useful idea, because OASDHI [Old Age, Survivors, Disability, Health Income] taxes and benefits are statutory in nature, and not guaranteed.? The “trust funds” are a legal fiction.? So, consider the entitlement programs as an extension of the federal budget, because that is what they are.

Time for a new blurring of distinctions.? The two parties in this case are the US Government and the Federal Reserve.? Let’s pretend they are one entity.? Why is this reasonable to pretend this?

Profits from the Federal Reserve go to the US Treasury.
The US Government appoints most of the critical members of the Fed’s governing board.
During the crisis, the Fed and Treasury worked hand in glove to achieve their ends.
The Fed takes actions that an ordinary Central Bank would not.? Why bail out Bear Stearns and AIG?? Why aid Fannie and Freddie?? Why buy mortgage-backed securities?? There is no reason for a central bank to own anything but the highest quality securities.

Much as Bernanke and others have protested about central bank independence, they have acted like an arm of the Treasury in most of 2008-2009.? So let’s stop the act, or let’s bring back men in the nature of Volcker, Martin and Eccles.? Tell Congress and the Executive that we are going to preserve sound money, and if they don’t like it, don’t reappoint us.

But suppose we continue on in the limp-wristed way that we have been going.? Maybe the US doesn’t have a Central Bank.? Maybe it has an additional financing arm.? Think of the Dollars you hold as o% 0-day commercial paper.? Think of the Fed encouraging banks to lend to them for the rate of less than 0.25%/year annualized on an overnight basis.? Consider their purchases of longer dated securities as similar to that of a hedge fund, admittedly a clumsy one, pasted onto our government.

So long as there is slack labor, slack capital, and slack resources, the cheap lending rates to the US government can persist.? But in the ’70s resources were not slack, and inflation occurred while there were recessionary conditions.? If the global economy is markedly stronger than the US economy, that could be our situation again — stagflation.

Central banks by their nature abhor two risks, credit risk, and lending long.? In the present environment, the Fed is doing both. Bagehot said to lend against impeccable capital at a penalty rate.? In the current crisis, the Fed, far from being independent, is absorbing credit risk, and lending long risk, and is doing so without abnormal compensation, indeed the compensation is sometimes subpar.

My sense is that when the Fed stops its purchases of mortgage bonds in the next few months, the longer-dated debt markets will cease to be so friendly, and rates will rise.? That is what should be happening.? It is risky to lend for long periods in US Dollar terms, and those that do so should be amply rewarded.

There are many who are arguing that the US should borrow more and spend with abandon.? They are fools; fools believe that the government can create prosperity through legislative or regulatory actions.? As it is, the creditworthiness of our government declines as we use its credit to bail out private interests.

We might not be as bad off as Greece, but what assurance do creditors of the US have that they will be repaid in purchasing power similar to that which they lent?? I don’t see the assurance.? Better to invest in the debt of non-PIIGS euro-debt. [PIIGS — Portugal, Ireland, Italy, Greece and Spain]

There is a lot of stress in the global economy as it attempts to reconcile economies that must export, no matter what, with those that must run deficits, no matter what.? The exporters take in debt from the nations that borrow in order to make books balance.? I don’t know when that system will break, but it will break, delivering losses to the exporters, much as that happened in the era of mercantilism.

That said, when the exporters lose, so will the countries that relied on the cheap financing, including the US.? Interest rates will be higher, and the US economy will be that much weaker, aside from exporters benefiting from a weaker dollar.? This may not take place for years, but it will eventually happen.

In other words, the cheap finance that the US has will eventually fail.? I don’t know when that will be, but eventually the world will tire of handing over goods for promises.

The Right Reform for the Fed

Posted on 28 November 200929 November 2009 by David Merkel

Ben Bernanke has an editorial in the Washington Post that attempts to defend the Fed.? Here is my discussion of his editorial:

These matters are complex, and Congress is still in the midst of considering how best to reform financial regulation. I am concerned, however, that a number of the legislative proposals being circulated would significantly reduce the capacity of the Federal Reserve to perform its core functions. Notably, some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation.

1) A fiat money system cannot control inflation without controlling credit.? Bank regulatory powers natively belong to the Fed as a result.? Rather than remove the regulation powers, give them to the Fed exclusively, so that we can watch them fail at the task without any charges of banks choosing their regulators.? There should only be one regulator of banks.? Let it be the Fed.

This is not to say the Fed has done a good job in the past.? Far from it.? But other regulators have failed as well.? Let’s have one regulator, so that we can assign blame when there is failure, and eliminate the errors in the long run.

2) Away from that, since Volcker and Martin, when has the Fed truly been independent?? When has it done something politically unpopular?? When has it done something that angered politicians?? Mr. Bernanke, your Fed has gone with the flow, and prostituted the credit of our nation to satisfy political ends, not protect the value of the currency.

The proposed measures are at least in part the product of public anger over the financial crisis and the government’s response, particularly the rescues of some individual financial firms. The government’s actions to avoid financial collapse last fall — as distasteful and unfair as some undoubtedly were — were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity, with profound consequences for our economy and society. (I know something about this, having spent my career prior to public service studying these issues.) My colleagues at the Federal Reserve and I were determined not to allow that to happen.

Moreover, looking to the future, we strongly support measures — including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system — to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is “too big to fail” — while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.

3) What the Fed did not do in the past it recommends now, that bankrupt institutions be taken through bankruptcy.? Duh, I recommended that many times in 2008.? There was no reason that any of the bailouts should have happened.? All we needed to do was follow existing law, and if no DIP lender showed up, the US Government could have played DIP lender, in order to liquidate the portions of complex institutions that were systematically important.

The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems.

4) There were regulators that did better, including Australia and Canada.

Working with other agencies, we have toughened our rules and oversight. We will be requiring banks to hold more capital and liquidity and to structure compensation packages in ways that limit excessive risk-taking. We are taking more explicit account of risks to the financial system as a whole.

We are also supplementing bank examination staffs with teams of economists, financial market specialists and other experts. This combination of expertise, a unique strength of the Fed, helped bring credibility and clarity to the “stress tests” of the banking system conducted in the spring. These tests were led by the Fed and marked a turning point in public confidence in the banking system.

5) Why should we believe that the Fed that did not use its powers to the full in the past, will do so in the future?? The Fed has had these experts available in the past, and did not use them.? What should make us think that they will be more successful in the future?? The failure to regulate properly is systematic.? There needs to be a change at the top of the Fed if it is to have a chance of regulating properly.

There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks, as demonstrated by the success of the stress tests.

This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed’s unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.

6) 1987 and 2001 were failures, not successes.? No policy accommodation should have been given.? Would Martin or Volcker have done it?? Financial firms need to learn to run with more slack capital for disasters.? As for the present crisis, please take credit for the glut of liquidity provided 2001-2004.? The Fed is to blame for that.? The kid gets no credit for saying, “Ma, I broke the window,” when she saw him do it.

7) The Fed should regulate systemic risk, because it creates the systemic risk.? No other reason.? Make the Fed tighten policy when Debt/GDP goes above 200%.? We’re over 350% on that ratio now.? We need to save to bring down debt.

Of course, the ultimate goal of all our efforts is to restore and sustain economic prosperity. To support economic growth, the Fed has cut interest rates aggressively and provided further stimulus through lending and asset-purchase programs. Our ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance, including lower inflation and interest rates.

Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities developed during the crisis. Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation.

We have come a long way in our battle against the financial and economic crisis, but there is a long way to go. Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.

8) The Fed has been anything but independent.? An independent Fed would have said that they have to preserve the value of the dollar, and refused to do any bailouts.? A transparent Fed would have full transcripts published within a year, not five years.? Testimony before Congress is a joke, because Congressmen use it to play for their own advantage, rather than overseeing the Fed.

I repeat what I have said before — If we had truly independent central bank governors like Volcker, Martin and Eccles, the Fed could work.? The Fed needs to work, or we may as well go back to a gold standard.

Given the? lack of independence of the Fed over the past 23 years, additional Congressional oversight could not hurt much.? Better that the Fed should have tough men as leaders, willing to stand up to the politicians and say no, we won’t inflate.? If we can’t have that, bring back the gold standard.? Gold is impersonal, and bends to the whims of no one.? It is a friend to those that want something fixed to rely on.

Book Review: Where Keynes Went Wrong

Posted on 28 November 200929 November 2009 by David Merkel

When I was a grad student, I always felt weird about Keynes.? I grew up in a home that was not explicitly “free market” but was implicitly so.? My Dad was a small businessman and my Mom was a retail investor (as well as home manager).? My Dad’s business did well, but it had its share of hard times, including the depression of 1979-1982 in the Rust Belt, where many of his competitors did not survive.? He had to be a member of the local union and run a closed shop, but as an owner, he had no vote in union matters.

I worked for my Dad for two summers.? During one of them, when we went to get parts, the parts dealer said to me,”I’ve heard good things about you.? Even the union steward has heard about you.”? My face and my Dad’s face went white. I was not in the union. After an uncomfortable pause, he said, “Eeeaaah! Got you!” and he laughed.? Dad and I looked at each other, embarrassed but relieved.

My Mom, like Keynes, and like me, has beaten the stock market for most of her life.? There are excess profits available for wise investors, some of which stem from the foolishness of other investors.

Keynes was a fascinating man who understood asset markets well, but when trying to consider the economy in general, looked to what would work in the short run.? The author of Where Keynes Went Wrong points out repeatedly from Keynes’ writings his view that interest rates are almost always too high, and that interest rates should only rise when inflation is rising quickly.? Can lowering short term rates juice the economy.? Yes, in the short run, but in the longer run it fuels inflation and bubbles.

The strength of Where Keynes Went Wrong is that it spends a lot of time on what Keynes actually said, rather than the way Keynesianism developed into a branch of Macroeconomics, eventually becoming part of the dominant macroeconomic paradigm — the Neoclassical Synthesis.? I admit to being surrprised by many of the statements Keynes made — granted, the author is trying to prove Keynes wrong so he goes after what is least defensible.

The author dissects the errors of Keynes into a few main headings:

Lower interest rates are almost always better.
Growth comes through promoting consumption.
You can’t trust businessmen to do the right thing when it comes to capital allocation.
Government planning is superior to decentralized planning, because experts in government can allocate capital better than businessmen.
Crashes require government intervention.? Using the balance sheet of the government will have no long run negative impacts.
Markets do not self-correct.
Globalization is good, and the nations of the world can cooperate on creating a standard of value independent of gold.

For the most part, those are my words summarizing the author.? After going through what Keynes said, he then takes it apart point-by-point.? The author generally follows the Austrian school of economics, citing Mises, von Hayek, and Hazlitt.

After that, the book continues by taking on the rhetoric of Keynes, both oral and written.? He was one sharp man in being able to express himself — orally, there were few that could match him in debate.? In writing, where time is not so much of the esssence, there is more time for readers to take apart his arguments, and point out the fallacies.? The author points out much of the fallacies in how Keynes would argue his points.

The book finishes by pointing out the paradoxes involved in Keynesianism, e.g., in order to reflate a debt-ridden system, the government must lower rates and borrow yet more.? Also shows how beginning with manipulating the money supply leads to greater intervention in credit, banking, currency, and other economic policies over time, and why the politicians love the increase in power, even if they realize that the policies don’t work.

One surprise for me was how many ways Keynes suggested to intervene in a slump, and how many of them are being used today.

Rates down to zero.
Direct lending by the Fed.
Directing banks to make certain loans.
Bailouts.
Nationalizing critical companies.
Inflating the currency.

The idea of letting the economy contract in any way was foreign to Keynes.? He felt that a seemingly endless prosperity could be achieved through low interest rates.? Well, now we have low rates, and a mountain of debt — public and private, individual and corporate.? Welcome to the liquidity trap created by Keynesian meddling, together with the way our tax code encourages debt rather than equity finance.

I recommend the book; it is an eye-opener.? It makes me want to get some of Hazlitt’s books, and, read the whole of Keynes General Theory for myself.? The book that my professors once praised as a tour de force has holes in it, but better to read it all in context.

Quibbles

The book could have used a better editor.? Too many things get repeated too often.? The book also has two sets of endnotes, one for reference purposes, and one for expanded discussions.? The endnotes that were expanded discussions probably belonged in small type at the bottom of the page rather than as endnotes.? Many of the endnotes are quite good, and it is inconvenient to have to flip to the back to see them.

Also, on page 274, the author errs.? The risk to a business owner is higher after he borrows money.? The total risk of the business is not higher, but the risk to the equity owner is higher.? Whether that risk is double or not is another question.

There’s another error on page 328.? When I buy stock in the secondary market, I am putting my capital to work, but someone else is withdrawing capital from the market.? There is no net investment.? When I buy an IPO, not only do I put my money to work, but there is more investment in the economy (leaving aside the venture capitalists that are cashing out).? It is hard to say when investment in the economy is increased on net.

The table on page 330 is confusing.? The first row should have been set apart to show that GDP is not a government obligation.

Finally, I don’t think that Say’s Law (“Supply creates its own Demand.” Or in the modern parlance, “If you build it, they will come.”) is true, but neither is its converse (“Demand creates its own Supply”).? The two are interconnected, and either one can cause the other.? Markets are complex chaotic systems, and entrepreneurs sometimes produce goods that no one wants.? Similarly, when consumers discover a new product or service, that demand can help create a whole new industry.? Supply and demand go back and forth — the causality doesn’t go only one way.

Who would benefit from this book: Send it to your Congressman, send it to your Senator.? Make sure every member of the Fed gets one, and the fine folks at the Treasury as well.? Beyond that, think of your liberal friends who think of Keynes as a hero, and give them one.? After reading this, I want to add Keynes’ General Theory to the list of books the everyone cites, and no one reads.? (That list: The Bible, Origin of the Species, The Communist Manifesto)

If you want to buy it you can get it here: Where Keynes Went Wrong: And Why World Governments Keep Creating Inflation, Bubbles, and Busts.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don?t buy what you don?t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

Book Review: This Time Is Different

Posted on 25 November 200925 November 2009 by David Merkel

I love economic history books.? The book that I am reviewing tonight is different because unlike most economic history books, it is mainly empirical rather than mainly anecdotal.

Don’t get me wrong, one good anecdote can deliver more information than a carefully controlled study.? But more often, it is the careful studies that reveal more in their bloodless way.

This Time Is Different takes the reader through the last eight centuries of financial crises globally, subject to the prevalence of available data.? Data is more available recently, so the A.D. 21st, 20th, and 19th Centuries get more play than the more distant past.? Also, the developed West gets more coverage than the East.? This is to be expected.? It all depends on who writes down more.

Crises? have been far more common than the average economics textbook would suggest.? One of the first ideas to toss out of economics should? be that markets strongly tend toward equilibrium.? My own empirical research in the financial markets indicates that mean-reversion is there, but very weak.

The book has a wide number of disasters that it draws us through, namely inflation/debasement, currency crises, banking crises, and internal and external default.

Now, all of these crises tend to happen more frequently than the modern fat, dumb and happy Westerner would like.? Central banking has substituted fewer and larger crises for more and smaller ones.

Regardless, the chapters on sovereign defaults are worth the price of the book.? Will defaults be internal, external, or both?? A lot depends on how much debt will be compromised through default.? If a majority of debt is held externally, foreign creditors should be wary.

This book is needed now because many so-called scholars implicitly assume that the US Government could never default on its obligations.? Yes, it would be a horror, but leading nations in the world have defaulted before, and they will do so again.? It is the nature of mankind that it is so.? Promises happen in good times, and defaults happen in bad times.

Quibbles:

The book is listed as 496 pages, but for non-academics the true length is more like 292 pages.

Also, I would suggest to the authors, that there are predictive variables that they have not considered regarding crises.? Two variables are growth in debt, and yield spreads.? Debt grows like kudzu or topsy prior to crises, and yield spreads are very small prior to crises.? As the crisis nears, debt growth slows, and spreads widen a little.

Summary

This book is not for everyone.? If you tire looking at tables, and prefer more discursive arguments giving anecdotes rather than facts, this book is not for you.

Who could benefit: if you want intellectual confidence that sovereign defaults /currency failures can happen even in the US (note we have had two so far, in addition to many other financial crises), this will give you confidence that you are not a nut.? If you want to educate one of your friends who thinks that such disasters are impossible, this is the book for him.? Just make sure he is willing to endure a semi-academic book.

If you want to buy the book, you can buy it here: This Time is Different: Eight Centuries of Financial Folly.

Full disclosure: I review books because I love reading books, and want to introduce others to the good books that I read, and steer them away from bad or marginal books.? Those that want to support me can enter Amazon through my site and buy stuff there.? Don’t buy what you don’t need for my sake.? I am doing fine.? But if you have a need, and Amazon meets that need, your costs are not increased if you enter Amazon through my site, and I get a commission.? Win-win.

Problems with Constant Compound Interest (4) (and more)

Posted on 24 November 2009 by David Merkel

At the meeting of the eight bloggers and the US Treasury, one of the differences was whether the recovery was real or not.? The Treasury officials pointed to the financial markets, and the bloggers pointed at the real economy (unemployment and capacity utilization).

With T-bills near/below zero, I feel it is reasonable to trot out an old piece of mine about the last recession.? But I will quote most of it here:

I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the ?auto companies were?dying.?

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On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?

A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts? Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.

It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don?t worry, we?ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus?s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:

I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn?t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don?t?

It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn?t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: ?There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,? Broaddus said. People shouldn?t ?expect too much from monetary policy? to steer the economy, he said.

When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, ?Broaddus says don?t expect too much from monetary policy.? Taken out of context, Broaddus?s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, ?Next time you talk to a Fed Governor, let us know, so we can make some money off it??

PS ? ?Before Broaddus answered, he said something to the effect of: ?I?m glad the media is not here, because they always misunderstand the ability of the Fed to change things.? ?A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.

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And now to the present application:

Why are commodities rising amid surplus conditions in storage?? Why is it reasonable to take over corporations when it is not reasonable to expand organically?? We are in a position where yields on short? Treasuries are nonexistent, investment grade and junk yields are low for corporates, and equities are rallying, but there is little growth, or some shrinkage in productive capacity.? Why?

The liquidity offered by the Fed is being used by speculators for financial positions, levering up relatively safe positions, rather than speculating on areas that are underwater, like housing and commercial real estate.? This is consistent with prior experience.? When the Fed does not allow a significant recession to occur, one proportionate to the amount of bad loans made, but comes to the rescue to reflate, what gets reflated is the healthy parts of the economy that absorb additional leverage, not the part that is impaired because they can’t benefit from low rates.? They have too much debt already relative to the true value of their assets.

That is why a booming stock market does not portend a good economy.? Banks aren’t lending to fund new growth.? They are lending to collapse capacity through takeovers.? ROE is rising from shrinking the equity base, not by increasing sales and profits.

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There is another current application:

Why do we buy commodities as investments?? Is it that we fear inflation in the short or long run?? Is it that it is a proxy for future prices for consumption in retirement, so we are hedging the future price level in a dirty way?

Think about it.? How do you transfer present resources to the future?? Most consumable goods can’t be stored, or require significant cost for storage.? Services can’t be stored; elderly people can’t store up health care.

Storage occurs through building up productive capacity that will be wanted by other at a later date, such that they will want to trade current goods and services for your productive capacity.? Storage also occurs by purchasing goods that do keep their value, and then trading them for goods and services you need when the time come to consume.

That is how one preserves value over time, and it is not easy.? It will be even harder if there are such disruptions to the economy that markets that are virtual do not survive.? (I.e. paper promises are exchanged, but their is significant failure to deliver at maturity.)

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In an environment where the government is playing such a large role in the economy, it is difficult to see how one can invest for the long term — when we are twisted between deflation and inflation, rational calculations are circumscribed, and simple judgments, such as buying out a competitor and shrinking the overall balance sheet are made.? In one sense, that is the rational thing.? Less capacity is needed.? But unemployment will rise.

That’s sad, but wage rates may be too high for some to be employed, given the lack of demand.? I view this as true in aggregate, but people that are aggressive in seeking employment are able to do much better.? I have seen it.? Even in a bad market, those that strive intelligently get hired.