Category: Currencies

The Biggest, Baddest Bubble of Them All

The Biggest, Baddest Bubble of Them All

Posted on by David Merkel

It’s election day, and I may as well try to fuse economics and politics for a moment.? Personally on an economic basis, I don’t think this election means that much.? Consider this post at RealMoney from earlier this year:


 David Merkel
Cultures are Bigger than Economies, Which are Bigger than Governments
1/7/2008 1:19 PM EST

To start this off, I don’t fit neatly on the political spectrum. I am an economic libertarian, socially a conservative, but utterly against the recent wars that we have pursued. I also think that we need to find a way to dismantle the two party system, but that will never happen. So now you have enough to disregard me if you like.

I don’t think the primaries make any difference at all. The three leading Democrats are all very alike. It doesn’t matter which one wins the primary. The Democrats would have their best chance with Obama, because general elections tend to be won on (sadly) which candidate is more likeable.

As for the Republicans, there are differences, but not to any great degree on likely economic policy. I say “likely economic policy” because none of their differential policies are likely to survive if one of them wins the general election. Any Republican win is unlikely to have that much of a mandate.

There are differences between the Republicans and Democrats on economic policy, but this is where my headline comes into play: “Cultures are Bigger than Economies, Which are Bigger than Governments.” Given the mismanagement of our government, particularly with respect to entitlement programs, though also costly wars, future governments will have less wiggle room. Raise spending, cut taxes? Go ahead and try. No surprise that the US Dollar continues to fall. Outsiders will eventually tire of funding US deficits in US currency.

The Republicans will leave the micro-economy more free than the Democrats, but aside from that, I don’t think the election matters much, at least as far as economics goes. There may be other reasons to vote for one side or the other, but pocketbook issues rank low for me, and in this election, the payoff from the differences will not be big.

Now, cultural change, in the unlikely event that it would occur, is another matter. But American history has been replete with big shifts before, and the economy and politics get dragged along. Perhaps the question to ask is what will be the next big shift in American culture? I don’t have any read on that now, but then, when it happens, it is often fast.

Position: none

Our biggest bubble, which is still inflating, are the debts of the US Government, both explicit and those not accrued for.? We are going to have a difficult time borrowing in the present for all of these new bailout/stimulus/pork programs.? Our debts are getting deeper, not shallower.

Consider this graph from this article at Clusterstock:

We may have a slight breather from the increase in total debt recently (2006-7), but it is going up in the near term.? My view is that we need delevering, and that will be a big theme in coming years once the government tires of the new policy of shifting private debts onto the public balance sheet.

Now, I’m still dubious that the bailout policy will work.? Reasons:

When a foreign holder of Treasuries is willing to give up 40 basis points of yield on a 10-year T-note yielding 3.80%, so that they can get paid off in Euros if there is a repudiation of US Treasury obligations, there is significant uncertainty over the creditworthiness of the US Government.? (That’s just an example, there are other reasons to enter into such a CDS.)

Now, the debt-to-GDP graph above doesn’t take into account pension and entitlement underfunding/non-funding.? From another comment at RealMoney:


 David Merkel
Digging a Hole to China (So We Can Borrow Some More)
10/28/03 08:26 AM?ET
With a gracious assist from one of our readers at Economy.com, here is the link I promised yesterday. The report does not break out one final number — one has to look at the “balance sheet” on page 58, and the “Statements of Social Insurance” on page 65, which they count as an off balance sheet liability, and add them up. It looks like this (in USD):

  • Net Liability: $6.8 trillion
  • Soc Sec, Pen & Dis: $4.6 trillion
  • Medicare, part A: $5.1 trillion
  • Medicare, part B: $8.1 trillion
  • Total: $24.6 trillion

    • This doesn’t take into account the value of land and certain less tangible assets that the U.S. Government has. It also does not take into account the considerable operating and capital lease liabilities, deferred maintenance, or liabilities for the GSEs, and other lending guarantee programs of the federal government.

    np

    That $24.6 trillion figure was from September 2002. As of September 2007, it would now be around $50 trillion. ( Here’s the link to the 2007 figures.? New figures out in two months.)? By the way, thanks Mr. Bush, for being such a reformer of Social Security and Medicare. You added on another $10 trillion of unfunded liabilities that future generations will have to fight over bear in your prescription drug program.? You have been the most damaging president on economics since Nixon.? (Sorry, I lost my cool. 🙁 )

    That $50 trillion does not count in state and corporate underfunding of pensions and benefits.? Oh, and with the fall in the markets, they want a bailout also.

    Who doesn’t want a bailout?? The US Government can just borrow some more to aid us on our way to prosperity.? Those debts and unfunded promises will have to be paid someday, either through taxes, inflation, or repudiation (total or external).? The economic mess at that point will be far worse than it is today for all those who rely on the US Dollar.

    Our problems in the US are larger than our politics.? It goes down to our very culture, borrowing from the future to take care of the present.? It is true for our Government, and many corporations and individuals.? The pain will come, the only question now is what form it will take.

    Fifteen Notes on the Markets

    Fifteen Notes on the Markets

    Posted on by David Merkel

    1) Where are we?? Is the equity market cheap or dear?? Personally, I think it is cheap, and though it might rally in the short run, it could get cheaper.? When the financials are compromised, all bets are off.? Here are some article indicating that things are cheap:

    And, not cheap, consider the arguments of this humble student of the markets.? He considers survivorship bias and war as factors that investors should consider.? I agree, and I would urge all to consider that wars often occur as a result of economic crises.

    2) The trouble is, quantitative finance is tough.? We don’t have enough data.? Our models are poor, and until recently, often reflected two major bull cycles, and only one bear cycle.? My view is that the equity premium is more like 3% over the long run, and not the 6% bandied about by careless consultants.

    3) During the “great moderation,” I argued over at RealMoney that volatility and credit spreads were too low, and would eventually snap back.? Okay, we are there now.? Volatility is high, and so are credit spreads.? The brain-dead VAR models used by Wall Street have been falsified again.? Quantitative investors have gotten savaged again; it only works when implied volatility is flat/declining — it is an implicit credit bet.

    4) This is a global crisis.? Where is it appearing?

    5) As I have mentioned before , the IMF, previously seeming irrelevant, has a new lease on life.? But how much firepower do they have, and will countries in crisis send them money to aid foreigners?

    Consider their new plans for a short term lending facility, and the exogenous shocks facility.? They will have a lot to fund in this environment.

    6) Might government programs to guarantee bank deposits have caused a shift from stocks to bank deposits?? Possible, though for every seller, there is a buyer.

    7) How do we pay back what we borrow?? Who will borrow more from us?? Those are? the great unanswered questions as we attempt to bail out many troubled entities.? I’m a pessimist here, and think that we will have higher long rates as a result, and that “Bernanke” will become a cuss word.? (Among the cognoscenti, only “Greenspan” will do as a proper insult.)? On the despondent side, will the US default in 2009?? Doom-and-gloomers are always early, and ignore the flexibility in the financial system prior to failure.? I see default as more of a 2017-2020 issue.

    8 ) Uh, let Lawrence Meyer pontificate.? There is nothing good about a zero Fed funds rate.? Let him wax grandiloquent about Japan over the past two decades.? Consider how low interest rates destroy money markets funds.? Consider as well how much low rates destroy saving, sometyhing that we have had too little of.

    9) In an environment like this, every M&A deal is open to question.? M&A is credit sensitive, and higher volatility impairs the flow of credit.

    10) I don’t think that GAAP mark-to-market accounting has had a material impact on this crisis.? True, many accounting firms have interpreted mark-to-market as mark-to-last-trade, but that is not what SFAS 157 specifies, and firms can ignore their auditors (with some risk).? The truth is that the firms that have failed choked on bad balance sheets and inadequate cash flow.? It doesn’t matter what the accounting rules are when a company is running out of cash.? Cash is impervious to accounting rules.

    11) Want a closer view of the Fed and politics.? Read this piece at The Institutional Risk Analyst.? While at RealMoney I espoused a view that the Fed was more political than economic.? This article confirms it.

    12) How do I view Greenspan’s apology?

    13) At a prior employer, we often commented that credit risk in credit cards appears late in the credit cycle.? Well, we are there now.? It is seemingly the last form of credit to default on.? In this environment, one can lose their home, but losing financial flexibility can be bigger.

    14) The FDIC can modify many mortgages, at a cost to taxpayers.? It could cost a lot, and many people who made dumb decsions could be bailed out by the prudent.

    15) If John Henry were alive, he would be smiling.? Let humans make markets, and not machines.

    Eight Notes and Comments on the Current Crisis

    Eight Notes and Comments on the Current Crisis

    Posted on by David Merkel

    1) Greenspan — what a waste.? A bright, engaging man becomes a slave to the Washington political establishment.? Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.? Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

    On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.? I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.? Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

    2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.? When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.? In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

    3) You want accounting reform?? Start with accounting that disallows gains-on-sale in a financial context.? WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.? No profits at sale.? Profits are earned in a level way over the life of the business as risk decreases.? Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

    4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.? Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

    5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.? Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying? recently.

    Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.? Once they reject their current pose, the equity market could rally.

    6) Is the economy weak?? Well, look at the states.? If their tax receipts are going down, so is the economy.? We are in a recession, and maybe a depression, given the lack of strength in the banks.

    7) Do we need a new system for managing the global economy?? The Chinese certainly think so.? They finance the US and don’t get much in return.? Perhaps China could host the new global reserve currency?? I don’t think so.? Their banking system isn’t real yet, and they still want to subsidize their exports.? The global reserve currency role will flow to the largest economy allowing free flow of capital.? Now, who is that?? Japan?? Too small, but the world now recognizes that their banks may be in better shape than many other countries.? Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.? The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

    Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.? The Euro is a creation of an alliance of nations untested by economic crisis.? Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

    For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.? (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

    8 ) On the bright side, some boats are rising.? After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.? The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”? That said, the developed market banks financing them will get whipped too.? This is truly a global crisis.

    And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?? I’m skeptical, as usual.? Perhaps the Treasury can send them a raft of T-bills.? The IMF can ask the Fed for contact info.

    (more to come)

    NOT Born and Bred in the Briar Patch

    NOT Born and Bred in the Briar Patch

    Posted on by David Merkel

    Originally, I was not a fan of Bernanke, but the more I read about him, the more I liked him.? Still, my main fear that I wrote about at RealMoney at the time of his nomination has largely been realized in my mind.


    		 David Merkel
    Why I Don’t Like Bernanke as Fed Chairman
    10/24/2005 12:09 PM EDT

    From my post on April 4th:

    “I’m not crazy about Ben Bernanke being selected chairman of the Bush administration’s Council of Economic Advisers. This is not because I think he’ll do a bad job there; odds are, he’ll do fine. It’s kind of a nothing job, anyway. I just suspect that this is a stepping stone to becoming the next Fed chairman. Bernanke is too much of a dove on inflation for me, and too seemingly certain of his own opinions. If we have very placid economic conditions, he could do fine as Fed chairman. If we have crisis conditions, the last thing I want is a dovish idealist as Fed chairman.”

    Greenspan was more of a political operative than an academic, and as such, fairly pragmatic as he threw liquidity at every crisis, creating a climate of moral hazard. Investors lose fear of loss, because monetary policy will bail them out in a crisis.

    Academics think they understand how monetary policy affects the economy, and in my opinion, have a higher degree of confidence in their views than say, a banker in a similar position would. When models of the world are imperfect, a false certainty can do a lot of damage. Bernanke is a bright guy, but bright doesn’t mean right.

    Position: None

    Bernanke spent a lot of time studying the Great Depression as a grad student, and I did not.? As an academic, there is the bias that says, “Yes, but we have learned from the past, and know what to do next time.? We have the game plan to fight Depression II set.”

    I think the wrong lessons were learned by Dr. Bernanke, and many academic macroeconomists.? They look at the ineffective remedies at the time: negative monetary growth, Smoot-Hawley, and lack of stimulus, and they conclude that if they can stimulate a lot more, they can avoid Depression II.

    Depressions occur because market actors take on too much debt, including financial institutions, and at the tipping point, cash flow proves insufficient to service the debt, starting a self-reinforcing bust cycle going the opposite direction of the prior self-reinforcing boom.? Once the self-reinforcing bust starts, I’m sorry, but there is little that can be done.? Liquidation of bad debts must happen to clear the system.? In the absence of that, we can have a Japan-style scenario where rates go to zero, and we stay in a funk, or we could inflate the mess away, harming savers and pensioners.

    The boom-bust cycle is normal to Capitalism and should be enjoyed, rather than avoided by policymakers.? A lot of smaller busts are better than one big bust when national debt to GDP levels are at record levels.

    At this point, stimulus merely slows down the inevitable.? We aren’t liquidating debts as much as transferring them to the government.

    I am waiting for the first Treasury auction failure.? They won’t call it a failure, and they may reschedule it.? When that happens, we will have a statement that shifting private debts to the US Government is not appreciated by the creditors of the government.

    We also could have semi-failures, where the market clearing rate at the auction is well above the average bid.? A few of those, and the yield curve could be at record wide levels.

    I view the Federal Reserve and Treasury as being a bunch of amateurs here.? That’s not an insult.? Take me, James Grant, or any number of bright critics of the Fed and Treasury, and if they were in charge now, they would be amateurs also.? There is nothing in their training that prepares them for dealing with the credit equivalent of nuclear winter.? Nor should there be.? These abnormal periods happen every 40-80 years whether we like it or not, once we forget the lessons of building up too much leverage under a fiat money system.

    Should they be blamed for not bailing out Lehman?? That was the inflection point for this crisis as it is manifesting now.? Yes and no.? Yes, since they took it upon themselves to be the guardians of the whole financial system.? Yes, since they bailed out Bear and AIG, two institutions that they had no business bailing out.? Both were bailed out for reasons relating to systemic risk, and both were politically unpopular.? But though Lehman may have posed less systemic risk than AIG, it certainly posed more risk than Bear.? Yes, because they jolted expectations.? No, because they couldn’t have known the full chain of events that allowing Lehman to fail would touch off.

    A hidden cost here is that activism begets more activism, or, at least, a demand for more activism.? If the Federal Government and the Fed are now the lenders of first resort, it is no surprise that many will come-a-beggin’.? Once you are willing to lend to support one critical area of the economy, my but many areas will deem themselves critical as well.? Where does it stop?? At this point, I think it might have been better to let Bear, Fannie, Freddie, and AIG fail, but with some sort of expedited bankruptcy process that quickly disposes of equity rights, and converts all debt claims into varying degrees of new equity.? This extinguishes debt claims, and accelerates the healing of the economy.? This would be true reform.

    Looking Forward

    Now, suppose for a moment that the monetary and fiscal stimulus programs work in the short-run, and bring down rates.? What happens when the Fed tries to exit?? My guess is that they can’t exit.? In paying interest on reserves, the Fed is slowly replacing the Fed funds market with its own lending.? If the Fed leaves, the crisis reappears.? But even apart from that, the government ends up with more debt, and that has to be serviced in some way.

    In providing guarantees to money market funds, buying top-rated CP, and helping financial firms finance paper of varying quality, the Fed replaces markets that ceased to function for a time.? The Fed sets yields and prices for credit, but with little to guide their decisionmaking.? Set the price too high, and there are few takers.? Too low, and there are many takers.? Beyond that, with so many programs, what is a bureaucrat to do to figure out which programs are offering the most relief?? I’ll tell you, it is not possible to figure that out.? The money going out is certain, but the benefits are not.

    Now, as Greenspan mumbles, wondering about how this crisis could have come about, those of us that are more aware (or intellectually honest), look at the increase in total debt levels and say, “It’s pretty amazing that the system held together for so long.”? It’s an ugly situation, but it is worth asking whether the current actions of our government might harm the future well-being of our nation.

    It’s almost never a good idea to sacrifice freedom for security.? But the Federal Reserve has done that.? They are now tied to the Treasury Department, and any policy independence they had is gone.? Book-smart Bernanke has been co-opted by the street-smart Paulson.? Bernanke is a bright guy, but he was not “Born and bred in the briar patch,” as was Paulson, who learned the ropes on Wall Street.? (Do I have to say that Wall Street produces harder characters than academia?? No?? Good.)

    In this case though, we are beyond normal, even for seasoned veterans of Wall Street.? There are no comparables any more.? This is more severe per unit time than 1973-4 or 2000-2.? Only the Great Depression remains as a benchmark, and that era grins at us as we think we can beat the process of delevering through government action, of which they had much.

    I’m not grinning here.? We are looking at tough times.? May the Lord help us.

    The Collapse of Carry Trades

    The Collapse of Carry Trades

    Posted on by David Merkel

    In his usual brief style, jck at Alea displays the collapse of carry trades through the appreciation of the yen.

    Put on your peril-sensitive sunglasses before viewing.? When I was at RealMoney, I wrote a lot about carry trades, and how the end would be ugly.? We are experiencing that now.


    		 David Merkel
    The Craving for Yield, Part 2
    2/6/2007 2:55 PM EST

    If you hang around bond investing long enough, you run into the phrase “carry trade.” It’s a simple concept where one borrows at a lower rate, and lends at a higher rate, just like any bank would do.

    Free money, right? Yes and no. People make money in these trades often enough to make them popular, but there are often points where they blow up. The simplest example is when the Treasury yield curve is very steep, like it was in late 1993, or mid-2003 right after Alan Greenspan finished his last contest of “How much liquidity can I provide?” At that point, it seemingly paid to borrow short and buy longer dated Treasuries, clipping the interest spread. That works well when interest rates are falling, or when the FOMC is on hold at the bottom of the cycle, but once the hint that the first tightening might occur, it doesn’t work well until the first loosening is hinted.

    Carry trades can involve other factors as well. Some creditworthy entity can borrow cheaply, and invest in less creditworthy or more illiquid paper, capturing a spread. That trade also goes in cycles; good to do it when everyone is scared to death, as in late 2002. Bad to do it in late 1999-2000, as the negative side of the credit cycle kicks in.

    Carry trades can involve different currencies. Borrow in the low interest rate currency (Yen, Swiss Francs, Offshore Yuan), and invest in the high interest rate currency (US dollars, NZ dollars, Australian dollars, Korean Won, Indian Rupee, etc.) Again, it all depends where you are in the cycle, as to whether this is a good trade or not. The weak tendency will be for low interest rate currencies to appreciate versus high interest rate currencies, but in the short run, currency movements are somewhat random.

    What fascinates me in the current environment is the size and variety of all the carry trades being put on at present. CDOs of all sorts. Borrowing in developed markets and investing in emerging markets currencies. Levering up nonprime commercial paper. Borrowing offshore in Yuan. Borrowing short to finance paper with short embedded call options. Corporate, RMBS, CMBS and ABS spreads are tight.

    When I think of all of the different risks that can be taken in bonds (duration, convexity, credit/equity, illiquidity, currency, etc.) they are all being taken now, and at relatively high levels. There is an exception. Duration risk is not being taken because of invested yield curves. (But who is borrowing long to lend short? Not many I hope.)

    The danger here is not immediate. As with most topping processes, it is just that, a process. Bubbles pop when cash flow proves insufficient to finance them. Cash flow is still sufficient now. Banks are still growing their balance sheets faster than their central banks. Petrodollars and Asian surpluses are still being recycled. Wealthy investors are still for the most part bullish. We’re not to the point of no return yet; the sun is shining amid large cumulus clouds. But as those clouds cumulate, we should prepare for rain. Okay, snow.

    Position: none

    Alas, but the boom has given way to a bust, and “All the king’s horses and all the king’s men, Couldn’t put Humpty together again.” Sad times these, but they had to come. There was too much leverage in the the system, and now leverage is collapsing, and the value of assets whose prices were artificially high due to the temporary additional purchasing power that leverage afforded.

    Have a wonderful day amid the chaos, and be grateful if you have food, shelter, clothing, family, friends, and peace with God.

    The Dependent Federal Reserve

    The Dependent Federal Reserve

    Posted on by David Merkel

    There was a great hoo-hah made in the ’90s and early 2000s over the grand importance of having an independent central bank, one that the politicians could not mold to their own ends.? This was largely during the Greenspan era, where the party line was independence, but Greenspan did what the administration wanted, no matter who was president.? Volcker was a better example of what an independent central banker was like, and as such, he was shown the door by Reagan.? Much as I liked Reagan, we would have been better off with Volcker, and better off with someone other than Greenspan.? (Ron Paul for Fed Chairman, baby. 😉 )

    I could talk about the social or political aspects of the Fed that makes it less independent of the Government:

    • They have worked together in other roles.
    • They are grateful for their cushy sinecures.
    • The Fed has a too-large employment base that they don’t want to draw attention to.
    • There is an aspect of mutual back-scratching.
    • No one wants to take abuse from Congress or the Treasury.? Best to go with the flow.
    • News coverage always favors loose monetary/credit policy in the short run.

    But I’m going to take another approach tonight, one that is more data-driven.? Here’s chart number one of the asset side of the Fed’s balance sheet:

    My, but look at how Treasuries owned by the Fed and not sold to them by the Treasury have disappeared.? The most common asset (maroon) has disappeared, and has actually gone negative.? Here’s a simpler version of the graph:

    Without the Treasury selling the Fed Treasury securities, the Fed would have run out of Treasuries with which to support its market intervention programs.? They are economically dependent on the Treasury.? That may have impact on their future decisions, not that the Treasury would want to ruin the Central Bank, after all they take care of the extra-constitutional stuff that the Treasury can’t.? Besides, it allows the Treasury to finance the government cheaply by issuing the Treasuries to the Fed.? The relationship is symbiotic.? What could be happier?

    I’ve made the comment before that we are heading down the path of Japan with a few differences.? The differences are summarized in my pieces Liquidity for the Government and no Liquidity for Anyone Else, and Inflation for Goods Prices, Attempted Inflation for Housing-Related Assets, but Sorry, No Inflation for Wages.

    Where we vary from Japan’s path of quantitative easing is that the money created from government credit in Japan was pumped into the banking system as a whole. In the US, it is pumped into the Fed’s plans to fix various lending markets. This article from The Economist has a good discussion of the similarities and differences.? Whether that will result in fixing those markets, or result in the Government/Fed becoming the one sole counterparty for those “markets” (with a difficult disentanglement) remains to be seen.

    In a financial crisis, there are no good solutions.? The good solutions existed 7-20 years ago when orthodox central banking was replaced with tinkering, through oversupply of liquidity in minor problems that should not be called crises, which allowed investors to build up the level of leverage, because the Fed always came to the rescue.? Also, many Fed Chairmen of the past (in the 50s, 60s, and Volcker) stood up to the Adminstration and Congress, and did not enable their policies.? The economy was healthier as a result in the intermediate-term.

    I’ve also said that Fed policy works through stimulating healthy parts of the economy, and that pulls the sick parts of the economy out eventually.? Well, because of the overleverage of the past, there are no healthy parts of the economy to work with.? I wish I could be more optimistic here, but given the path that the government is taking, I see the explicit debt of the US Government going to 100%+ of GDP before the system stabilizes, just in time to leave us overleveraged for our entitlements crisis.? At least the debt is denominated in US dollars. :(? How long will our lenders continue to honor that?

    We face painful choices over the next 20 years partly as a result of the policies of the last 20 years.? 20 years of pain… hmm… that sounds like Japan as well.? Let’s pray for a better outcome.

    Recession or Depression?

    Recession or Depression?

    Posted on by David Merkel

    Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

    Here’s my knockoff of S&P’s proprietary oscillator:

    That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

    I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

    This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

    Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

    With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

    Entering the Endgame for Monetary Policy, Part II

    Entering the Endgame for Monetary Policy, Part II

    Posted on by David Merkel

    Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

    As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

    By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

    Credit: The Economist

    I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

    There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

    Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

    What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

    • Inflation when the Fed monetizes the debt,
    • Depression from vastly increased taxes,
    • Debt repudiation (whether internal, external, or both), or
    • Japan-style malaise for a long time.

    Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

    Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

    All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

    As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

    PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

    Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

    Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

    Posted on by David Merkel

    These are the times that try my soul as a portfolio manager.? During crises, I am forced to make tradeoffs of the short-, intermediate-, and long-terms.

    • Short-term: technical oversold/overbought-ness.
    • Intermediate-term: valuation levels.
    • Long-term: what industries benefit from economic change?

    This is a difficult balancing act.? What makes matters more complex here is trying to understand what impact the actions of the Fed/Treasury are likely to have on the Dollar.? I hope to have another post up on the balance sheet of the Fed, for now, here’s the graph that Ron Smith called “the hockey stick.”

    As I note in the graph above, the changes are even larger than the change in the weekly average figures.? Now, this isn’t presently going to be inflationary, because the Fed is (sort of) acting as an agent for the US Treasury in bailing out lending markets.? The US Treasury creates T-bills or notes, gives them to the Fed, and the Fed uses them as collateral in their collateralized lending programs.

    The difficulty comes here: it’s easy to create these programs, but hard to shut them down.? Now the Fed will buy commercial paper.? Talk about unbacked paper money, CP is unsecured by any assets of the company receiving the loan.? jck at Alea rightly calls this not-so-wee beastie the Super-SIV.? As I commented there:

  • # 1 David Merkel Says:
    October 7th, 2008 at 9:58 am     I think you pegged it calling it the Super-SIV. As I commented in late 2007 as the Fed began this series of interventions in lending markets, it is easier to start these actions than to complete them. It is hard to estimate all of the consequences.Just as I think George Bush, Jr., started to go wrong when he concluded that he had found his mission (fight terrorism, without boundaries), Ben Bernanke faces a similar problem (do whatever it takes to stop the Second Great Depression, without boundaries).

    History is being made here, and it will be volatile?

    And jck responded:

  • # 2 jck Says:
    October 7th, 2008 at 10:14 am     one thing we know for sure, is that the policy of ?promoting? liquidity appears to have backfired, no reasonable person would claim that markets are functioning better now than when they started?in fact some people would say they are a lot worse.
    as you say David, very hard to get out of this, I don?t expect to see a normal Fed balance sheet, i.e treasuries_t-bills in my lifetime.
    I will pop in for a comment on your euro piece a bit later?busy???

    • The question is: what are the endgames for these programs… TAF, CPFF. PDCF, TSLF, TARP, the bailouts of Bear and AIG, etc?? Once a market gets a taste of cheap credit, it is difficult to get them to give it up; they begin to depend on it.

    And there are more demands for use of the credit of the US Government.? Bill Gross wants Fed funds at 1%, and wants the Fed to guarantee that institutional transactions clear.? Sounds simple, but the devil is in the details.? The essentially means that the Fed takes short term risk of financial firms failing while securities are in the course of settlement.? The losses could be significant in a crisis, but so could the calming effect.

    The Treasury/Fed hopes that if they can calm the markets, eliminating fear of cascading defaults, eventually the markets will regain a tolerance for risk, and they can slowly eliminate the new lending programs.? My sense is that is the Japanese solution, and we are still waiting after two decades to see if it works.? Other “solutions” include:

    • Inflating away the value of the promises made. (I.e., monetizing some of the T-securities that have been printed and given to the Fed.)
    • Increasing taxation to pay for the credit losses from the bailouts.
    • Creating a two-tier currency system, where foreign lenders get paid back in a cheaper currency, but domestic lenders don’t get so badly affected.
    • Or, a combination of the above four.? Like jazz, I think policymakers are making it up as they go along, and will use a wide variety of solutions.

    And, all of this hinges on the willingness of those who buy Treasury and Agency securities to continue to do so.? On the bright side, the disarray in Europe is making the US Dollar and Japanese Yen more attractive, giving the US the opportunity to issue more debt at a time when it will be needed for the TARP.

    I come down on the side of an eventual inflation, monetizing the debts of the US Treasury, though that is a minority opinion at present.? It certainly isn’t showing in the TIPS market.? Take a look at one of Greenspan’s favorite graphs, five year inflation, five years forward:

    After six years of stability in this statistic, expected inflation has gone over Niagra in a barrel.? Call me a nut, but I like TIPS even more here.? Very cheap inflation insurance, which I think we will need when this comes into its endgame.

    Most of the pressure is toward a lower Fed funds target rate, but given that the Fed has sterilized their prior cuts, I don’t see what great good it will do.? It just gets us closer to the zero bound, after which, Japanese quantitative easing exists, and the infamous helicopters of Friedman and Bernanke.? As it stands now, I don’t put much credibility in a Fed funds rate cut.? The Fed seems committed to using its balance sheet to intervene in lending markets, not the more traditional stimulus of the economy as done in the past.

    Truth, I am not sure where this ends, but from my recent discussions with Ron Smith and Dr. Jeff Miller, the solutions aren’t easy or pretty.? The time to have acted was 5-15 years ago, and we don’t have a wayback machine.

    You’re Owed Euros

    You’re Owed Euros

    Posted on by David Merkel

    The Euro has been falling recently versus the Dollar.? Why?? There have been many theories proposed, but I want to offer my own theory this evening.? Fiat currencies are political creatures, and are only as strong as the political entity issuing the fiat currency (fiat — it’s currency because we say that it is).

    The intersection of politics and economics is tricky.? Currencies, and confidence in currencies are ephemeral.? I look at the Eurozone and ask a simple question: who stands behind the Euro?? Who will lay out tax revenues to support it in a crisis?? Who will be the lender of last resort?

    Much as I did not like the bailout plan because I think there were many better plans to pursue, nonetheless, the US has the benefit that the US Treasury and Federal Reserve are acting like one unit.? In the Eurozone, there is no central taxation, regulatory banking, or police authority; there is no lender of last resort.? Individual governments or “coalitions of the willing” may bail out financial companies, but there are no guarantees because the ECB and European Parliament are toothless.? If the same conditions existed in the US, regional Federal Reserve Banks would do the bailouts, and not the Central Bank.

    When I was on “The Ron Smith Show” two weeks ago (sorry, no podcast), I commented that the credit crisis was a global phenomenon, and the European banks were more levered than US banks, though with less credit stress as a percentage of assets.? I pointed out that there is no lender of last resort, and that many countries have different goals for currency policy, and bank regulation.? I also noted that the criticisms of American finance were valid, but applied to Continental Europe as well.

    At present, those Europeans that dissed Anglo-American finance have egg on their faces (including the lady who shares my surname).? With the competitive rush in Europe to guarantee bank deposits, even Germany switched its policy and guaranteed deposits.? That hasn’t happened in the US yet, but I wouldn’t rule it out.

    It is possible that the current crisis could destroy the Euro, and possibly the EU.? I think of the Confederation, where the economic pressure became so great that an extra-constitutional coup took place to create the Constitution, and implicitly, the fiat Dollar that we live with to this day.? WIthout political unity, fiat currencies have short shelf-lives.? Alternatively, the crisis could create a Federal Europe where the central government has significant powers to the degree that France in the Eurozone would be similar to Texas in the US.? I don’t see that as likely; there is not the same degree of trust across the Eurozone as there is in the US.

    What’s my upshot here?? Extreme volatility does not favor the Euro; it calls their system into question.? Better to be in the Dollar, or better yet, the Yen, Swiss Franc, or Norwegian Kronor.? Carry trades are play on low volatility; when volatility rises, the low interest rate currencies tend to do well because the ability to hedge bad currency outcomes is diminished, and carry trades collapse.

    That’s where we are now.? Neither the US nor Europe should gloat over the other’s bad providence.? They have their own unique weaknesses.