September 2010

Been watching the pre-market, looks pretty sedate at the moment. Maybe today I can short AAPL again. Bastards.

“You can’t cut debt by borrowing.” How often have you read or heard this comment from “austerians” (a nice variant on “Austrians”), who complain about the huge fiscal deficits that have followed the financial crisis?

The obvious response is: so what? Shifting debt from people who cannot support it to those who can – the population at large, both now and in future – seems to make a great deal of sense if the alternative is an economic collapse that leads to a loss of output and investment now and so of income in the long term. Indeed, under the latter alternative, even the fiscal deficits may end up little, if any, smaller if one tries to slash them, as the UK could be about to discover.

Before leaping to that conclusion, however, let us approach the issue of de-leveraging – or debt reduction – analytically. Between 1994 and 2007, total US non-financial private debt rose from 118 per cent of gross domestic product to 173 per cent, the highest level in US history. Over the same period, US financial sector debt rose from 54 per cent of GDP to 115 per cent. A great deal of this leveraging up of the economy (matched elsewhere, notably in the UK) was based on false premises: borrowers and lenders thought that the assets against which they had borrowed would be worth more than turned out to be the case.

How, then, can people reduce their indebtedness or restore their net worth, after an unforeseen fall in asset prices? There are three mechanisms: sale; bankruptcy; and frugality. Let us consider each of these, in turn. But remember that, at the global level, debt cancels out: net debt is zero. So, in paying down debt, one is also reducing credit by an equal amount.

People with assets that they no longer wish to hold and debts they no longer wish to bear, can sell the former to repay the latter. If this is to cancel debt, then the ultimate purchaser needs to be a creditor. Sale makes this a voluntary transaction.

This path to de-leveraging is going to be part of the story. But when the predominant asset is housing, as it is now, the willingness of creditors to purchase will be limited. By and large, people who wish to buy houses are young and have limited liquid assets. Most creditors already own houses. In theory, houses could be sold to cash-rich foreigners. But that, too, is going to be a limited avenue for economy-wide deleveraging in most countries. (In Spain, however, sale to cash-rich foreigners seems a more plausible solution, since much of the past construction was designed for their use.)

The second approach is mass bankruptcy. In this case, creditors are forced to write down their loans to the value of the asset. That is clearly an important part of any de-leveraging. But since highly leveraged financial intermediaries stand between the ultimate creditors (households) and the ultimate debtors (other households), mass bankruptcy is going to wipe out the capital of intermediaries. That is likely to trigger panic, as losses cascade across the financial system.

Organising such a bankruptcy procedure, to allow for a mass adjustment of claims, is indeed one of the necessary conditions for managing a financial crisis efficiently. But it is going to be politically and technically complicated. In the end, however, a substantial part of the debt and the corresponding credit should be eliminated in this way. The big policy decision is how far the state wishes to socialise the losses of creditors. The answer will certainly include some socialisation, since governments insure deposits in financial institutions.

The third approach is repayment. Under any imaginable resolution of the debt overhang, some people are going to seek to pay down their loans. Indeed, a great many are going to try to do so: those who dislike the idea of bankruptcy, including the stigma; and those whose assets are worth not much less than their loans. To these groups of higher savers should be added those who are simply poorer than they thought they would be and so decide to save more.

While the highly indebted and the newly “asset-poor” have good reason to spend less than before the crisis, creditor households have no reason to spend more. Indeed, the collapse in interest rates in a slump lowers their incomes and so is quite likely to make them want to cut back on their spending, too. The aggregate effect of these changes in behaviour is, of course, a rise in the desired household rate and so the desired financial surplus of the household sector.

It is a matter of simple logic, that, since the financial balances of the household, corporate, government and foreign sectors must sum to zero, a rise in the surplus of the household sector must be offset by an offsetting move in other sectors.

During a post-crisis recession, the surplus of the corporate sector always rises, as it has done now, because managements slash investment. In the current crisis, increases in the surpluses of the non-financial corporate sector in high-income countries have been particularly large. In fact, non-financial corporate sectors were running substantial financial surpluses in the high-income countries before the crisis and are running still bigger surpluses now.

A shift in the foreign surplus means a shift towards surplus in the current account of the debt-burdened economy. That takes time. It also requires changes in the balance between saving and investment in the rest of the world. In practice, surplus countries do not want to make the adjustments needed to allow the US, UK and other former deficit countries run huge current account surpluses at full employment levels of income. So this way out is also largely blocked, alas.

When one has eliminated everything else, it turns out that the only sector both able and likely to offset a large move of the household sector towards financial surplus in a post-crisis slump is the government. Indeed, that is exactly what has happened.

My conclusion, then, is the exact opposite of the conventional wisdom with which I began: the only way that the private sector can de-leverage, when large economies are in a post-crisis recession, is for the government to leverage. The economy, as a whole, cannot de-leverage in any other way, other than via accelerated mass bankruptcy, which would certainly deepen the recession, if not create a depression. If the government tried to eliminate its deficit over night, it would have to drive the private sector back towards balance (or achieved a massive shift in the external balance very swiftly). In the context of excessive debt, that is only going to happen if private sector incomes are so squeezed that paying down their debt is no longer feasible. But in this situation, mass bankruptcy and a slump again becomes a likely outcome.

The latter is, indeed, what now threatens peripheral European countries forced to reduce fiscal deficits at exactly the time when their households are trying to pay down their debts and corporations are slashing investment. I fear the outcome of this hair-shirt policy, which is likely to break the will of some countries and, quite possibly, the eurozone itself.

So the least bad way to deal with a huge debt overhang has three elements: facilitate mass bankruptcy of the hopelessly over-indebted; lower interest rates, so making it easier for the indebted to carry and pay down their debt; and accept large fiscal deficits as a way of sustaining the incomes of those trying to pay down debts. The recommended alternative of slashing the fiscal deficit while the private sector tries to slash its debt suffers from a fallacy of composition: it is impossible for all sectors of the economy to spend less than income at the same time.

Of course, as this process proceeds, private debt should fall and public debt rise, relative to GDP. Is this a big problem? In some countries, the answer will be: yes. These countries will have to go through massive debt restructuring in the private and, quite possibly, public sectors. But other countries, notably the US, are perfectly able to run large fiscal deficits, financed, if necessary, by the central bank. At the end of this multi-year process of private sector debt restructuring and repayment, the private sector will be in balance once more and able and willing to spend. Meanwhile, the higher level of debt can be carried quite easily. So long as the real interest rate on government borrowing is not much above the real growth rate, stabilising the level of public debt to GDP does not even require a primary fiscal surplus.

Now, assume, that in this newly restored economy, the fiscal deficit is largely eliminated. Then, over time, the ratio of public debt to GDP can be brought down through the normal process of economic growth. Making structural changes in fiscal policy that control spending in the long run makes this more credible.

In short, not only can we deal with the private sector debt overhang by increasing the fiscal deficit, but we must do so. It is the only way of avoiding a deep slump and the immense disruption of mass bankruptcy. But this is not to preclude debt restructuring, as well. It is important to develop ways to restructure private debt, too. But, for this to happen, we must be prepared to impose more losses on financial intermediaries and so on their creditors.

Analysis of the economy is not the same thing as analysing a single household. What is true of the latter is not true of the former. The unwillingness to recognise this truth will lead to serious policy mistakes.

CNBC (the infinitely more credible European edition) has run a stunning interview with Cazenove technical strategist Robin Griffiths in which the banker discusses such taboo items as the Plunge Protection Team’s intervention in the market for the month of September in a last ditch effort to keep stocks from tumbling following the horrendous August performance. First Griffiths dissects POMO: “One of the reasons [for the surge] is POMO: what happens is the Fed buys Treasurys off the banks, the banks put the money into the market…That amount of money turns the algorithms up, then all the algo trading hits the market. Real life investment managers are not doing this buying. They know that equities are for losers.” And the stunner: “The S&P is being effectively goosed up by the Plunge Protection Team – they can keep doing this for a little bit longer… But according to me the April high will not break…as…all of those Keynesian stimuli did not work.” As for bonds: “There is an old saying, don’t buy the Fed – yields will go down. Even now you should be buying bonds and not equities. The bubbles never burst when wiseheads in the media tell you it’s a bubble that’s gonna burst, they burst when they’ve given up on that and tell you this time it’s different.”

Sept. 23, 2010
Democratic leaders in the House of Representatives will move ahead with a bill allowing the US to retaliate against China for manipulating its currency, a significant escalation of the dispute between Washington and Beijing.

Sander Levin, chairman of the ways and means committee in the House of Representatives, said on Wednesday the bill would be compatible with World Trade Organisation rules.

But in a largely untested area of trade law the measure will evoke opposition from Beijing and could lead to a legal challenge in the WTO. The bill will go to committee on Friday and could be voted on by the full House as early as next week.

“This bill is being advanced in the absence of effective action on a multilateral basis,” Mr Levin said.

Hours later, Wen Jiabao, the Chinese premier, told business leaders in New York that pressure on Beijing was unwarranted.

“The conditions for a major appreciation of the renminbi do not exist,” he said. If the renminbi were suddenly to rise by a large degree against the dollar, “we cannot imagine how many Chinese factories will go bankrupt, how many Chinese workers will lose their jobs, and how many migrant workers will return to the countryside… China would suffer major social upheaval”.

Congress seem pretty much ready to start creating tariffs against Chinese imports to reflect their belief of the Yuans undervaluation. This is likely to spark a number of tit-for-tat measures worldwide and set the scene for a return to the collapse in world trade that the Smoot-Hawley tariffs instigated in the 1930’s.

Then, they managed to find some economists who at least had an idea, today? The Bill still passed and the rest is history. Today, again, we have the same choice. My bet – the dimwits pass it yet again and we plunge the world into a trade war.

I’ll close out the position here.

Looks like another bad start to the week for moi.

The physical needs for food, water, shelter, clothing, and basic comforts could be easily met for all humans on the planet, were it not for the unbalance of resources created by the insane and rapacious need for more, the greed of the ego. It finds collective expression in the economic structures of this world, such as the huge corporations, which are egoic entities that compete with each other for more. Their only blind aim is profit. They pursue that aim with absolute ruthlessness. Nature, animals, people, even their own employees, are no more than digits on a balance sheet, lifeless objects to be used, then discarded. ~ Eckhart Tolle, A New Earth: Awakening to Your Life’s Purpose

There has been an epic debate over on TPC’s blog on this subject, triggered by the Tepper comments regarding equities. The MMT brigade have seriously clouded the water.

First off, what actually is a definition of QE?

Quantitative easing describes a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system.


Through purchasing interest-rate sensitive securities with money it has created ex nihilo [out of nothing] The purchases, by way of account deposits, give banks the excess reserves required for them to create new money.

First then, how did the banks acquire the interest bearing securities? Banks take deposits: [i] demand deposits [ii] time deposits. They are different and should be treated differently by banks, but they are not. The reasons are as follows: a demand deposit legally must be 100% available to its owner. Under fractional reserve lending, this is not the case. A time deposit is callable after the contracted period of time, or with penalties if called early. Time deposits are savings. Demand deposits are cash balances.

[i] Banks pay interest to attract deposits from the Private sector. By paying interest, they need to invest that money at a higher return [interest] than they are paying. The type of deposit that they attract is important to their lending policy. In practice, it is immaterial, they lump them altogether for loans policy. They then purchase a higher interest asset than the cost of their deposit. Their profit is the spread.

[ii] In the lead up to the financial crisis, banks could fund via the capital markets selling short securities, or borrowing funds short-term, thus negating the requirement for deposits – relending the funds at higher rates, thus earning the spread, while creating a duration mismatch. While the money markets were willing [and able] to constantly roll over short-term debt, the inverted pyramid grew higher and wider.

[iii] The new loans made, created X10 further new loans via fractional reserve lending, thus the credit pyramid grew ever larger – until the losses via the sub-prime market sparked the contraction [reversal of the fractional reserve expansion] which spread to all corners of the credit markets.

The Federal Reserve steps up and starts to purchase all toxic credit instruments and places them on their Balance Sheet for two main reasons [i] the Fed does not actually need to declare values marked-to-market [ii] ultimately the taxpayer pays.

The Banks stabilise. Crisis [financial meltdown] averted. That’s where we were just prior to the advent of QE. First off the rank of course was the obligatory interest rate reduction at the short end. Then paying interest on reserves [all reserves, not just excess] Then QE.

What are excess reserves?

Excess reserves are funds that can legally [what a joke] be loaned, which then become the driver of X10 fractional reserve loans, which is again a credit expansion.

The MMT argument centres around the fact that the Banks are not lending to Mainsteet. They then conclude that there is no lending, thus there is no expansion of the money supply, thus inflation is, if not impossible, certainly highly unlikely.

However the Banks are lending. They are lending to the Federal Government, who is spending the money like a drunken sailor.


[i] The Federal Government via the Treasury floats a bond auction to raise money for expenditures. [ii] The Primary Dealers [banks] + any foreign sovereigns, bid on the bond issue. They pay cash. [iii] Some little while later, the Primary Dealers sell their newly purchased bonds back to the Federal Reserve who create ex nihlo, new electronic deposits, or new money. [iv] Treasury floats a new bond issue – wash, rinse, repeat.

So clearly, QE creates new money, it expands the monetary base.

The reason Mainstreet is screaming, is of course that Mainstreet is not receiving any of this new money via loans. The Government is expropriating the money, with kickbacks to the banks, the two need each other after all, and then spending this money on what the government believes will win it votes in a re-election. The purpose being, as always, to retain Power.

So where are they spending your money?

QE is simply another way to plug the holes in government spending. Spending that has been largely created through the creation of the Welfare State. Socialism.

QE is necessary because the rest of the world who once either could or would fund US expenditures, now cannot or will not.

How long until the whole country?

Correlations come, and they go. Is this the case with the Stockmarket and the 2yr Treasury? If not, then something is going to give: either stocks will sell-off, or, Bond Yields will rise [Bonds will sell-off]

Essentially it seems as if the Federal Reserve is trying to keep two balls in the air simultaneously: the Stock ball and the Bond ball. To do this they need to certainly continue with QE1.5 at the very least, and likely at some point a return to transparency via QE2. The return to QE2 will probably require a crisis [again]

One victim of QE1.5 is, and will be the US dollar. As we speak it is reaching dangerous levels technically on a chart basis, which is reflecting the underlying policy of QE1.5, which is required to keep both stocks and bonds unconvergent.

I think that this chart is incredibly optimistic. A fall in deficits from 9% of GDP to 2.5% of GDP in 2yrs? How exactly might that happen?

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