KOO: THE GLOBAL SLOWDOWN IS BECOMING MORE PRONOUNCED

The Pragmatic Capitalist:

Few people have a better grasp on the current economic predicament than Richard Koo. Koo is growing increasingly concerned about the state of the global economy and now believes the slowdown is becoming more pronounced:

“Signs of a slowdown in the global economy have become more prominent over the last two weeks. The deceleration in economic activity was reflected in the US jobs report and new unemployment claims, European industrial output, and Japanese consumer confidence. It was also reported on Monday that Japan’s inflation-adjusted GDP grew only 0.4% y-y in the Apr–Jun quarter, confirming that the recent slowdown actually began this spring.

This string of weak data led to a further correction in equities and pushed bond prices higher (and yields lower). Strong demand for government debt was underlined by yields ofsubstantially less than 3% for the 10-year Treasury note and less than 1% for the 10-year Japanese government bond.

In Ireland and some other countries in the eurozone, meanwhile, marked economic weakness fanned concerns about the future, leading investors to sell bonds and send interest rates higher.

In the currency markets, the narrowing yield differential between Japan and other nations prompted further buying of the yen, which set a new post-Lehman high of 84.72 against the US dollar.”

Koo is quick to note that the recovery we’ve seen since the Lehman collapse was primarily a mean reverting recovery that took us back to where we should have been in the first place had there been no Lehman related panic:

“That means that the rally that started about six months after the Lehman-inspired financial crisis was actually just a recovery from the Lehman crisis and not from the global housing bubble collapse in 2007.

The recovery from the financial crisis of 2008–09 was destined to run out of gas once economic activity rebounded to the (depressed) level where it would have been as a result of the balance sheet problems. I think that is what we are now observing in the US and Europe (Exhibit 1).”

“In other words, the level of economic activity has returned to where it would have been if Lehman Brothers had not been allowed to fail.”

Koo is increasingly concerned that governments have already begun down the wrong path of austerity:

“But governments in the UK, Ireland and Spain have already changed course and are pursuing austerity policies. Even in the US, it remains to be seen whether the Bush tax cuts and the Obama economic stimulus can be extended.

The recovery from the 2008–09 financial crisis has now run its course, clearing the fog surrounding the balance sheet recession. But I suspect that more time and even weaker economic data will be necessary before people understand this and accept the need for further fiscal stimulus.”

In particular he is very worried about Europe and the actions taken by Trichet:

“Against this backdrop, I am particularly concerned by an opinion piece contributed to the 23 July Financial Times by ECB President Jean-Claude Trichet and titled, “Stimulate no more—it is now time for all to tighten.” In the article, Mr. Trichet argues that the economic recovery is already under way and that the fiscal stimulus administered by national governments over the past two years should be quickly withdrawn.

Mr. Trichet also argues that the series of fiscal stimulus packages unveiled by the G20 two years ago was actually a mistake and says it was unfortunate that some countries had administered stimulus without any need for it. Now, he says, it is time for all countries to pursue medium-term fiscal consolidation strategies.”

Koo believes Trichet is wrong because, like Bernanke, he has misunderstood the balance sheet recession. He believes Trichet is becoming “more German than the Germans” and is directly contributing to the recovery in that single nation while the periphery burns. Ultimately, he says Trichet is making the same mistakes as Bernanke – believing that austerity and monetary policy should rule the day. Richard Koo, who has been right thus far, says they still fail to understand the balance sheet recession. It looks to me like he’ll continue to be right.

The Trader’s Mindset

Charts Gone Wild:

I wrote this article on March 15, 2009. It’s been well over a year and I know that many new folks have never seen it before. During this month, I’ll do re-postings of my best educational content because new folks who barely know me never got the chance to read my past posts from 2008/2009. It’s also nice for me to edit the articles to make them slightly better, otherwise known as ’2nd edition posts’. If you read my archives, then it’s simply nice to have a refresher once in a while. I do hope the re-print articles help in some way.

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Plutchik’s Wheel of Emotions

As you know by now, psychology is a secondary interest of mine, after reading charts and tarot cards, of course. For this week, I decided to cover the “trader’s mindset” and the most common psychological issues that all traders deal with.

How does someone know that they reached the trader’s mindset? Here are a few characteristics:

1. No anger whatsoever.

2. Confidence and being in control of the self

3. A sense of not forcing the markets

4. An absence of feeling victimized by the markets

5. Trading with money you can afford to risk

6. Trading using a chosen approach or system

7. Not influenced by others

8. Trading is enjoyable

9. Accepting both winning and losing trades equally

10. An open mind approach at all times

11. Equity curve grows as skills improve

12. Constantly learning on a daily basis

13. Consistently aligning trades with the market’s direction

14. Ability to focus on the present reality

15. Taking full responsibility for your actions

Developing the trader’s mindset takes time.

Let’s take 100 traders using the same trading system or approach. It is highly likely that two of them will not trade a system exactly the same way in all aspects. Why is this? Because our mindsets, beliefs, and understandings are unique. It is no surprise that most traders fail and the reason why is because they lack the trader’s mindset.

There are two parts to fixing any psychological problems:

1. Recognizing that it exists

2. Accepting it so you can move on

In trading, this is where it’s so crucial to take responsibility for your own actions because it induces change and you can start making improvements. If you don’t recognize and accept a problem, then you won’t get anywhere!

What are some of these issues that I speak of? Here are a few along with their causes and/or effects (these 15 issues are not meant to perfectly coincide with the above 15 mindset characteristics):

1. Anger over a losing trade – Traders usually feel as if they are victims of the market. This is usually because they either 1) care too much about the trade and/or 2) have unrealistic expectations. They seek approval from the markets, something the markets cannot provide.

2. Trading too much - Traders that do this have some personal need to “conquer” the market. The sole motivation here is greed and about “getting even” with the market. It is impossible to get “even” with the market. Trading too much is also indicative of a lack of discipline and ignoring set rules. This is emotionally-driven.

3. Trading the wrong size – Traders ignore or don’t recognize the risk of each trade or do not understand money management. There is no personal responsibility here. Typically, aggressive position sizes are used, however if risk is not contained, then it could spiral out of control. Usually, this issue comes from traders wanting to make a huge killing. Maybe they do win, but the point is that a bad habit emerges if a trader repeats this behavior.

4. PMSing after the day is over – Traders are on a wild emotional roller coaster that is fueled by a plethora of emotions ranging throughout the spectrum. Focus is taken off of the process and is placed too heavily on the money. These people are very irritable akin to the symptoms of premenstrual syndrome (something I wouldn’t know about personally).

5. Using money you can’t afford to lose – Usually, a trader is pinning his/her last hopes to make money. Traders fear “losing” the “last best opportunity”. Self-discipline is quickly forgotten but the power of greed drives them, usually over a cliff. Here, the rewards are given more attention and overall personal financial risk is ignored.

6. Wishing, hoping, or praying – Do this in church, but leave this out of the market. Traders do not take control of their trades and cannot accept the present reality of what’s happening in the market.

7. Getting high after a huge win – These traders tie their self-worth to their success in the markets or by the value of their account. Usually, these folks have an unrealistic feeling of being “in control” of the markets. A huge loss usually sobers them up pretty quickly. It’s important to maintain emotional restraint after wins, just as you would for losses.

8. Adding to a losing position – Also known as doubling, tripling, quadrupling down, typically, this means that the trader does not want to admit the trade is wrong. The trader’s ego is at stake and #6 comes into effect as the trader is hoping the markets will “work in their favor”. If you are wrong, you have a near 0% chance of making a full recovery.

9. Compulsive trading – Similar to #2, except these traders have an addiction to trading and quite possibly gambling issues. They need to constantly trade, even if there is no rational reason to do so. They are always excited whether they win or lose. These traders will trade in all environments and usually trade when it’s advisable to sit out.

10. Afraid of “pulling the trigger” – This usually means that the trader does not have a system or approach already in place. They have not calculated risk/reward and many times, these trades are unplanned. This also comes after a string of losses. They don’t want to be “wrong again”. There is no trust from within and an obviously lack of confidence.

11. Over-thinking or second guessing – Similar to #10, but these people are usually looking for a “sure thing”, when they clearly don’t exist. Losing is not recognized as a normal part of trading and the risks and unknowns of trading are not fully accepted. These traders cannot make decisions in the face of the unknown.

12. Limiting profits or getting out too early - These traders do not have a plan. There is a direct effect from believing that profits were undeserved…a typical reason for giving them up. Usually a trader is stressed over a trade for some reason and closing the position quickly eliminates the anxiety. Usually, there is a fear of “giving back” those gains.

13. Fear of being stopped out – Traders fear failure and the pain from taking losses is great. Here is another instance where the ego is at risk. They must always be correct or suffer a feeling of “let down”. Don’t forget that your stop loss is your last line of defense.

14. Not following your system – This is a trust and follow-through issue. Perhaps the trader didn’t test it enough, or it recently produced a string of losses, casing some doubt. Your faith in the system is broken. Not only do you not trust the system, you can’t even trust yourself with picking one that works for you. Find and stick with one that is consistent and ‘fits’ with your personality and style.

15. Following other traders (indiscriminately) – These traders do not have a system. They are also limited in trading knowledge. They feel that they will become winners if they simply “follow” someone. These trades are usually impulsive. It’s too dangerous to follow without cause.

The key to all things is creating balance. Remember, it takes time and discipline. The important thing here is to recognize the issues and learn to seriously accept them and take responsibility for your actions. When you finally recognize and accept each of these common pitfalls, you’ll be well on your way to acquiring the trader’s mindset.

Keynesian End Game – Fooled By Stimulus.

TraderSutra:

Nassim Nicholas Taleb wrote a fabulous book called Fooled By Randomness. It’s a treasured part of my library and will stay so to the day I die. Everyone should read it and then read it again. I won’t go into too much specifics, but it’s all about how investors as well as humans in general often are unaware of the existence of randomness. We tend to explain random events as non-random. Often from this we over analyze and over estimate causality. We tend to make the simple complicated and the complicated simple. When in fact the random happens all of the time and that most are unprepared for it because our belief systems are so out of whack. We have years of ingrown cognitive biases that distort our view of the world and its surroundings.

My point here is not to talk about randomness per say but to talk about being fooled. World markets are currently being fooled into thinking that Keynesianism is going to save us all. In fact, it’s the opposite. Keynesianism will be the hammer to the nail to the coffin to what Neo Classical Economics started. Policy makers and central bankers around the world have been indeed “Fooled By Stimulus.” The idea that exponential increases in debt and leverage will eliminate debt and leverage is at the foremost zeitgeist of Central Bank circles. This one single toxic theme has permeated almost all policy circles. Cheap debt begets more cheap debt. Bankers get drunk off of cheap debt because they can always invest somewhere to gain the spread.

Most central bankers call the Keynesian Theory of Economics the “Beautiful Theory.” This was the most influential economic theory of the early 20th Century. It saved us from the depths of the Great Depression. It is also currently the preeminent theory that is housed today. Keynes was an exceptional thinker who alerted all that financial markets are inherently unstable, Hyman Minsky said similar things in greater detail decades later but it was Keynes who mentioned it first. Keynes also had this Gem, “In the long run we are all dead.” Western democracies needed an approach to balance free market capitalism with government initiatives. Keynesianism was the approach. But all “beautiful” things inherently hide some ugly truths. Like the super model who has an eating disorder, and the gorgeous porn star who comes from a broken home. At the end of the day it all comes out on the wash.

I believe that the Keynesian miracle is dead. The game is over. The stimulus programs have not reduced unemployment and not spurred the real economy. America is currently running two economies and it’s the financial economy that Keynesianism has greatly helped at the expense of the real economy. This is the great divide in our country. It’s not Democrats V. Republicans. That’s too easy. It’s the Have V. Have Not’s. The debt costs used to prop up the financial economy has a direct consequence to the real economy for generations to come.

http://tradersutra.blogspot.com/2010/08/dual-economies-busted-financial-system.html
Keynesian economics was born with the publishing of John Maynard Keynes’ 'The General Theory of Employment, Interest and Money.” This theory states or advocates a mixed economy, predominantly driven by the private sector, but with significant intervention by government and the public sector. Keynes argued that private sector decisions often lead to inefficient macroeconomic outcomes, and advocated active public sector policy responses to stabilize output according to the business cycle. Keynesian economics served as the primary economic model from its birth to 1973. It lost some of its luster during the high inflation and subsequent stagflation in the 70’s, but made a comeback during the credit crisis of 2007-2008.

This crisis rejuvenated Keynesian policy and we then received the following from government:
-TARP
-TALF
-American Recovery/Reinvestment Act
-QE
-ZIRP
-Cash For Clunkers
-HAMP

Most of these programs were indeed geared to bailout the financial economy. It had very little effect on stabilizing the real economy but the financial economy just reloaded on the cheap debt.

This type of policy basically makes the point that we can have debt and credit expansion if the economy also grows with it. A rising tide lifts all boats. The rising tide really is a debt tsunami that is going to drown us all. Deflation will be the prevailing theme for developed economies for the foreseeable future. This is why the Fed is obsessed with a busted QE policy. Deflation is poisonous to levered risk assets. What typically happens after we have deflation is mass monetization of bad debt which undoubtedly leads to hyper inflation or general destruction of all Fiat currencies. Hyper inflation is not prices spiraling upwardly out of control, it’s the loss of confidence in ones currency. The Keynesian End Game is total and complete debt monetization which will lead most investors to give up on fiat paper currencies. Any wonder that gold and silver are all in rally mode? What should be happening is debt restructuring and outright default. This would cleanse economies and make lending much more responsible.

The prevailing wisdom of ever expanding debt loads being offset with stronger economies have been around for a long time. It worked all through the 1960’s. The debt loads were high but world economies were just getting in line and economies were able to grow. This made the debt load manageable. Many were worried about corporate debt loads, deficits, and personal debt burdens, but world economies powered higher. The critics were all wrong and looked like idiots.

Statistics on almost all types of debt showed a high correlation between their increases and increases in measures of economic health like the GDP, average personal net worth, and the country’s standard of living. This marched on for decades, but underneath the beauty was a sleeping slug. Over the years, the dollar increase in debt necessary to generate a dollar increase in GDP kept growing. In the late 1940’s and 1950’s, it took about a one dollar increase in debt to generate a one dollar increase in growth, but in each succeeding decade the amount of debt necessary to generate a dollar increase in GDP kept growing. Through the most recent decade, it seems to have taken more than five dollars of debt to produce one dollar of growth, and over the last few years the numbers might have gone into reverse, or perhaps only toward infinity, as all the increase in debt does not seem to create any growth.

Debt used to be the answer but it is increasingly becoming the wrong answer for our current ills. What are the alternatives? Painful ones I presume, that is why that they still alternatives. The easy thing to do is print and monetize debt. The world has not seen a reduction in debt levels since the Great Depression and it is painful obvious that debt reduction is what is needed but will not be implemented until all is lost.

Going back to the correlations of debt and GDP. We see that global GDP especially US Economic growth was 100% credit generated. The 2000-2007 boom was all about residential construction and homeowners using their homes as ATM machines. When the credit boom collapsed, we saw both economic and credit contract. From this policy makers instituted a ZIRP to try and reinflate past bubbles via animal spirits. In the past this worked but presently most Americans are experiencing a balance sheet recession, and no matter where short rates are most are in secular deleveraging mode. Expansionary monetary policy is failing because the debt levels are enormous, as an expansion of credit has lost its power to stimulate growth. As such a reduction in debt levels coupled via restructuring and outright default of debt will have a devastating effect on economic output. What we are experiencing and seeing before our own eyes is the Keynesian End Game. A dead end for Risk Markets .

Just from this logic I can deduce: Forget a double dip recession. The vast amount of Americans never fully recovered from the 2007-2008 credit crisis. A new depression has begun. There will be massive amounts of new debt issued around the world by Central Bankers, this only delays the process of recovery as new debt will not stimulate growth but only keep alive zombie financial institutions. Eventually there is no other option than to restructure/default the debt load. Global debt loads need to shrink and shrink fast. Only after this catharsis where the debt is purged can we can realistically think of growth via reflation.

Be unreasonable - play the uber trade to keep your investment mojo

This article comes from Long Room, part of Financial Times blog Alphaville. I find it bit more bearish than usual stuff, but doesn't Japan have two decades of deflation? Is the debt we accumulated repayable? Answer is obviously yes for the first question and no for the second. But honestly, I still don't know how will the world look in 5 years. And if somebody says he know... don't trust him :)

There is only one investment idea you need to think about right now.  All other investments are for a later date post the appearance of the uber trade.  As this is a singular trade diversification is not useful and could be costly.  You can pick up your various alphas or carry trades (in all its forms...ultimately wealth creation is a carry trade) if you must but know most will be unpicked by the uber trade.  As economics and markets are not fair when panicking even the 'fundamentally good' carry trades will be taken out and shot.

We are  undoubtedly high in the trajectory of the greatest most global leverage bubble ever seen.  As we have lived with this 'profitably' for 14 months post the 'end of the world' (long risk, any risk = bingo) we are complacent about it.  The world is incremental...politicians, consumers, journos, companies, intellectuals and particularly the hallowed markets and their participants (of which I am one)...even Bob Janjuah, Marc Faber, Jeremy Grantham to name but a few 'radicals' are also incrementalists in their insightful contrarian ways...in many ways the incrementalism of the general market participants irritates me most as it has such a deluded perception of its own radicalism and role.  As an aside I point out the ubiquity of data and information increases the weight and momentum of the incrementalist trundle.  (Please note, this is not an anti market polemic as I believe that free and simply regulated markets are awesome and their potential to constantly project the profit motive, or adjust when they realise they have been wrong, is the best system we can have...and we must take the volatility that comes with that as it is completely obvious there isn't a better solution).  It is the meeting of this incrementalism with the POTENTIAL of the uber trade that we should fear.  In some incremental, risk weighted world inhabited by all you very clever market people the uber trade may not be given a certainty of 100%...we could argue about it and give it 'reasonable' weights of say 5-50%...wide margin as its academic and I don't want to argue about reasonable stuff and this is the most stupid time ever to be reasonable

Of course, there is no uncertainty to the uber trade now.  The only uncertainty is when and how it blows.  The reason that there is not uncertainty and there is no scope to be intellectually reasonable is that once the markets sufficiently recognise the not insignificant presence of the uber trade then they will be drawn into pricing it and it becomes an inevitability....no cleverness of economic or monetary management can save us from it.  The stupendous gamma and rapid delta in the realisation finishes the game and makes it 100% certainty.  Its futile, don't argue with me if you think what I say is remotely true then the only options are 0% or 100% at this stage of the game....I know to say this irritates your intellectual prowess and desire to be reasonable/incremental...but get over it quickly as the market thinks quicker than all of us (wisdom of crowds is true)

The uber trade is created by the peak of the leverage mountain and the debt deflation this now heralds.  It may be slow to deflate for a bit...but that will only be as people may be slow to work out the significance of what it means to be on the downward slope...once they catch on incrementalism will turn all helter skelter.  The deeply embedded market and political wish that we can role the debt, even create some more, and then inflate it away is just a fairy tale born of canned historicism, herd thinking (thats after all what similarly educated people do who also enjoy the same ubquitous media feedback) and no little amount of hubris (as we have 1920's style belief in the wisdom of the masters of the market).  What is happening in Europe shows that the myth that debt can be used to grow out of debt bubble has been broken....of course the current inertial momentum of market believes this myth still...however this is one of those delicious schizoid paradox's of the market that happens near momentous times whereby if one could take and isolate each 'opinion former' in the market and ask what they think of this myth you would find a strong majority against.  Accept this and you instantaneously must conclude that credit creation (inc govt) must go into reverse so we have no fuel for the inflation fire (it is not likely - possible imo - that private sector credit appetite and money velocity ignites at this point - if you think otherwise then you should know you are a fantasist and not wise and balanced market operator you perceive yourself to be!).

And here's an alternative take on the 'friendly' inflation delusion.  To have global friendly inflation requires massively co-ordinated policy and action.  It will not come through some miracle of the market.  And it needs to be global and co-ordinated as easily observable and comparative advantages springing from differential experience will create quick and viscous feedback loops (remember we are coming from ridiculous debt level point so room for error is non existent).  Just look at the 1920's experience of reattachment to the gold standard by encumbered economies (much less than today by the way!) and how lack of 'fair play' and co-ordination led to destruction.  Sooooo, it becomes rather simple, without the ability for 'benign' inflationary adjustment the only option is debt deflation and this will destroy some demand so we will experience actual economic deflation

We have no choice to go the old fashioned deflation route out...capital cleansing must occur (and that is another reason why the inflation route is not plausible).  Our wonderful broad based proletarian economies and what we have learned about money (ie gold is sickness and fiat money is useful fantastical stuff) means that we will be able to avoid severe depression...but we will have a depression... particularly China where it will be huge as it has ultimately been the key recipient of the global credit boom in recent years.  The myth of Chinese political and strategic foresight will shown for the nonsense it is.  Yeah, what's happened in China has been quite spectacular and good in many respects...but it is an emerging market command economy where capital has been suboptimally deployed in massive scale.  Its not hard to work out, forget all the specific positives you can say about some elements of Chinese development and just remember that all emerging phases suck in huge amounts of capital (there is always some form of egregious credit creation....the carry trade gone mad even though it was originally rational) and then destroy it - China is no different no matter what GS tells you or all the various cheerleaders on the ground giving expert witness to its realness and greatness - just remember that the vast majority of them are in fact as clueless as you are even if they do get to write intellectual or 'insider informed' pieces in the FT or get to go on CNBC.

So, how do we get out of our deflation? Fortunately it is a naturally process,  wealth is impaired but it survives and once asset values fall sufficiently more than the fall in wealth we get the credit-less lead recovery whereby spontaneous investment begins to take place (good govt  may help support this but shouldn't try to create the process).  Rational greed kicks in.

What's the uber trade?  Long treasuries and dollar, take the debt of some other nations too (hedged) like Germany and UK if you must but really diversification isn't useful.  Hold some cash too particularly in US. Then hold net short position on ALL risk assets...yes, everything!  Particularly gold that most wonderous  of miscalculations!

I am not telling you that I know it is tomorrow.  But I believe that the Europe thing has taken us past the delusional stable equilibrium of the last 14 months and catastrophic instability could come anytime.  Don't be incremental about this!  Remember where the debt level is, remember the 'goodwill' and co-ordination that needs to come to keep us on track for painless inflationary delivery and, probably most of all, remember that we have reached the end of a generational narrative on how the economy and markets work....this lack of narrative to fit what is coming is the intangible catalyst that means markets will take us to the deflationary future no matter what politicians try

Good luck

Your optimistic mojo

PS related to others posts...I think that Germany may be the significant country closest to getting this and that the UK is catching on too.  The US seems furthest from the truth of it and quite hilariously think that it is the rest of the world that is sick and they are healthy!

IMPORTANT NOTICE

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QUANTITATIVE EASING: “THE GREATEST MONETARY NON-EVENT”

The Pragmatic Capitalist:

The topic of quantitative easing (QE) has rapidly become the most important discussion in the investment world. As deflation becomes the obvious risk and the economic recovery looks increasingly weak investors are again looking to the Fed to save their skin from a Japan style deflationary recession. The irony here is so thick you could choke on it, however, like some sort of sick masochist, investors continue to return to the trough of the Federal Reserve so they can gorge on half-truths and misguided policy responses.

There is perhaps, no greater misunderstanding in the investment world today than the topic of quantitative easing. After all, it sounds so fancy, strange and complex. But in reality, it is quite a simple operation. JJ Lando a bond trader at Goldman Sachs has eloquently described QE:

“In QE, aside from its usual record keeping activities, the Fed converts overnight reserves into treasuries, forcing the private sector out of its savings and into cash. This is just a large-scale version of the coupon-passes it needed to do all along. Again, they force people out of treasuries and into cash and reserves.”

Some investors prefer to call it “money printing” or “stimulative monetary policy”. Both are misleading and the latter is particularly misleading in the current market environment. First of all, the Fed doesn’t actually “print” anything when it initiates its QE policy. The Fed simply electronically swaps an asset with the private sector. In most cases it swaps deposits with an interest bearing asset. They’re not “printing money” or dropping money from helicopters as many economists and pundits would have you believe. It is merely an asset swap.

The theory behind QE is that the Fed can reduce interest rates via asset purchases (which supposedly creates demand for debt) while also strengthening the bank balance sheet (which entices them to lend). Unfortunately, we’ve lived thru this scenario before and history shows us that neither is actually true. Banks are never reserve constrained and a private sector that is deeply indebted will not likely be enticed to borrow regardless of the rate of interest. On the reserve argument the BIS explains in great detail why an increase in reserves will not increase borrowing:

“In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

The aggregate availability of bank reserves does not constrain the expansion directly. The reason is simple: as explained in Section I, under scheme 1 – by far the most common – in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system. From this perspective, a reserve requirement, depending on its remuneration, affects the cost of intermediation and that of loans, but does not constrain credit expansion quantitatively.

The main exogenous constraint on the expansion of credit is minimum capital requirements. By the same token, under scheme 2, an expansion of reserves in excess of any requirement does not give banks more resources to expand lending. It only changes the composition of liquid assets of the banking system. Given the very high substitutability between bank reserves and other government assets held for liquidity purposes, the impact can be marginal at best. This is true in both normal and also in stress conditions. Importantly, excess reserves do not represent idle resources nor should they be viewed as somehow undesired by banks (again, recall that our notion of excess refers to holdings above minimum requirements). When the opportunity cost of excess reserves is zero, either because they are remunerated at the policy rate or the latter reaches the zero lower bound, they simply represent a form of liquid asset for banks.”

The most glaring example of failed QE is in Japan in 2001. Richard Koo refers to this event as the “greatest monetary non-event”. In his book, The Holy Grail of Macroeconomics, Koo confirms what the BIS states above:

“In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession. If there were many willing borrowers and few able lenders, the Bank of Japan, as the ultimate supplier of funds, would indeed have to do something. But when there are no borrowers the bank is powerless.”

In the same piece cited above, the BIS also uses the example of Japan to illustrate the weakness of QE. The following chart (Figure 1) shows that QE does not stimulate borrowing (and the history of continued economic weakness in Japan is coincidental):

“A striking recent illustration of the tenuous link between excess reserves and bank lending is the experience during the Bank of Japan’s “quantitative easing” policy in 2001-2006. Despite significant expansions in excess reserve balances, and the associated increase in base money, during the zero-interest rate policy, lending in the Japanese banking system did not increase robustly.”

(Figure 1)

Koo goes a step further in describing the failure of QE to promote private sector recovery. His simple example is one I have used often:

“The central bank’s implementation of QE at a time of zero interest rates was similar to a shopkeeper who, unable to sell more than 100 apples a day at $100 each, tries stocking the shelves with 1,000 apples, and when that has no effect, adds another 1,000. As long as the price remains the same, there is no reason consumer behavior should change–sales will remain stuck at about 100 even if the shopkeeper puts 3,000 apples on display. This is essentially the story of QE, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”

Koo continues by emphasizing how ineffective monetary policy is during a balance sheet recession:

“Even though QE failed to produce the expected results, the belief that monetary policy is always effective persists among economists in Japan and elsewhere. To these economists, QE did not fail: it simply was not tried hard enough. According to this view, if boosting excess reserves of commercial banks to $25 trillion has no effect, then we should try injecting $50 trillion, or $100 trillion”

After years of placing more apples on the shelves the Bank of Japan finally admitted that the policy had been a failure:

“QE’s effect on raising aggregate demand and prices was often limited” (Ugai, 2006)

That all sounds too eerily familiar, doesn’t it? No, no – Mr. Bernanke hasn’t failed. He just hasn’t tried hard enough….But perhaps the reader believes Japan is different and not applicable. This is a reasonable objection. So why don’t we look at the evidence from the last round of QE here in the USA. Since Ben Bernanke initiated his great monetarist gaffe in 2008 there has been almost no sign of a sustainable private sector recovery. Mr. Bernanke’s new form of trickle down economics has surely fixed the banking sector (or at least bought some time), but the recovery ended there. It did not spread to Main Street. We would not even be having this discussion if we were in the midst of a private sector recovery. The surest evidence, however, is in the Fed’s own data. We can also look at the Fed’s recent Z1 to show that households remain hesitant to borrow (see Figure 2). Friday’s consumer credit data was yet another sign of contracting consumer credit and a lack of demand for borrowing. Despite the Fed’s already failed attempt at QE (see Figure 3) we are convinced that Mr. Bernanke just needs to throw a few more apples on the shelves. The historical evidence is clear – QE will do little to stimulate borrowing and help generate a private sector recovery.

(Figure 2)

(Figure 3)

In addition, there is one great irony in all of this misunderstanding. The hyperventilating hyperinflationists and those investors calling for inevitable US default are now clinging to this QE story as their inflation or default thesis crumbles before their very eyes. The new hyperinflationist theme has become a story of “if this, then this, then THIS!” – the ludicrous 3 step investment thesis that the economy will become so fragile that the government will pile on with more stimulus, which will worsen matters and force them to stimulate further which will then result in hyperinflation and/or default. Most investors have enough trouble predicting what the next event will be – connecting the dots two or three steps down the line is not only ill-advised, but is hardly even worthy of consideration….Let’s just call a spade a spade – the inflationistas have been wrong and the USA defaultistas have been horribly wrong.

What is equally interesting (in addition to the fact that QE is not economically stimulative) with regards to this whole debate is that this policy response in time of a balance sheet recession is not actually inflationary at all. With the government merely swapping assets they are not actually “printing” any new money. In fact, the government is now essentially stealing interest bearing assets from the private sector and replacing them with deposits. This might have made some sense when the credit markets were frozen and bank balance sheets were thought to be largely insolvent, but now that the banks are flush with excess reserves this policy response would in fact be deflationary - not inflationary. Why would we remove interest bearing assets from the private sector and replace them with deposits when history clearly shows that this will not stimulate borrowing?

All of this misconception has the market in a frenzy. Portfolio managers and day traders can’t wait to snatch up stocks on every dip in anticipation of what they believe is an equivalent to the March 9th 2009 low that was cemented by government intervention. As I have long predicted Ben & Co. have failed. If there is one thing that we know for certain over the last 24 months it is that Mr. Bernanke’s monetary policy has done very little to get the private sector back on its feet. This man failed to predict the crisis (was in fact oblivious to its potential), initiated the wrong trickle down policy response and yet now we turn to him to save us from a double dip and his Committee responds with more discussion of QE? Will we ever learn?

In describing the negligence of such monetary policy Richard Koo uses the analogy of a doctor who simply tells his patient to take more of the same medicine he originally prescribed:

“At the risk of belabouring the obvious, imagine a patient in the hospital who takes a drug prescribed by her doctor, but does not react as the doctor expected and, more importantly, does not get better. When she reports back to the doctor, he tells her to double the dosage. But this does not help either. So he orders her to take four times, eight times, and finally a hundred times the original dosage. All to no avail. Under these circumstances, any normal human being would come to the conclusion that the doctor’s original diagnosis was wrong, and that the patient suffered from a different disease. But today’s macroeconomics assumes that private sector firms are maximizing profits at all times, meaning that given a low enough interest rate, they should be willing to borrow money to invest.. In reality, however, borrowers – not lenders, as argued by academic economists – were the primary bottleneck in Japan’s Great Recession.”

Dr. Bernanke has misdiagnosed this illness one too many times. At what point does someone tell him to put the scalpel down and step away from the table before he does even greater harm?

References

BIS (2009) http://www.bis.org/publ/work292.pdf

Koo, R (2009) The Holy Grail of Macro Economics

Ugai, H (2006) Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses. Bank of Japan Working Paper Series no 6-E-10

Finally

Big day today

Deleveraging and balance sheet recession

Richard Koo has a nice article in The Economist about balance sheet recession. He has there very interesting point:

The private sector will not be responding to the talk of inflation or inflation targeting because it is responding to the fall in asset prices, not consumer prices.

In times of deleveraging households are repaying their debt and they do everything to minimize borrowings. But if the value of their debt is too high, it becomes impossible to repay it. So the only choice is default. This chart summarize it nicely. Too bad I don't know the source of it.

The gap between the the value of debt and value of properties is too large and without asset prices inflation it cannot be solved. So the only way for FED is to inflate and print money...

Original article from Koo is worth reading:

Is America facing an increase in structural unemployment? No, America lacks the necessary commitment to stimulus.

THERE is no reason for structural unemployment to increase following an ordinary recession or financial crisis. However, the US today is suffering from a balance sheet recession, a very rare ailment which happens only after the bursting of a nationwide debt-financed asset price bubble. In this type of recession, the private sector is minimising debt instead of maximising profits because the collapse in asset prices left its balance sheets in a serious state of excess liability and in urgent need of repair. When the private sector is deleveraging even with zero interest rates, the economy enters a deflationary spiral as it loses aggregate demand equal to the sum of unborrowed savings and debt-repayments every year. If left unattended, the economy will continue to contract until either private sector balance sheets are repaired, or the private sector has become too poor to save any money (=depression). The last time this deflationary spiral was allowed to materialise was during the Great Depression in the US.

In this type of recession, monetary policy is largely useless because people with balance sheets underwater are not interested in increasing borrowings at any interest rate.  There will not be many lenders to those with impaired balance sheets either, especially if the lenders themselves have balance sheet problems. The private sector will not be responding to the talk of inflation or inflation targeting because it is responding to the fall in asset prices, not consumer prices. The money supply also contracts when the private sector de-levers because bank deposits, the largest component of money supply, shrinks when the private sector draws down its deposits to pay back its debt. During the Great Depression, the US money supply contracted 30% mostly for this reason.

Since the government cannot tell the private sector NOT to repair its balance sheets, the only thing the government can do to keep the economy going is for the government to borrow and spend the unborrowed savings in the private sector and put them back into the economy’s income stream. In other words, fiscal stimulus becomes indispensible in a balance sheet recession. Moreover, the stimulus must be maintained until private sector deleveraging is over.

The problem is that in a democracy, it is extremely difficult to maintain fiscal stimulus during peacetime. As can be seen in the US, UK and in so many democracies around the world today, the demand for fiscal consolidation overwhelms the policy debate once the initial fiscal stimulus manages to stabilise the economy. Not realising the critical danger posed by private sector deleveraging at zero interest rates, those who push for fiscal consolidation argue that a big government is a bad government and that the wasteful deficit is jeopardising the future of our children and grand-children. 

When the deficit hawks manage to remove the fiscal stimulus while the private sector is still deleveraging, the economy collapses and re-enters the deflationary spiral. That weakness, in turn, prompts another fiscal stimulus, only to see it removed again by the deficit hawks once the economy stabilises. This unfortunate cycle can go on for years if the experience of post-1990 Japan is any guide. The net result is that the economy remains in the doldrums for years, and many unemployed workers will never find jobs in what appears to be structural unemployment even though there is nothing structural about their predicament. Japan took 15 years to come out of its balance sheet recession because of this unfortunate cycle where the necessary medicine was applied only intermittently. 

The real impediment to a sustained recovery from a balance sheet recession therefore is the inability of orthodox academics and policy makers to accept the fact that the private sector is minimising debt and that their aversion to fiscal stimulus based on the assumption that the private sector is maximising profits is unwarranted. If Japan had known that it had actually contracted a different disease and kept its fiscal stimulus in place until the private sector balance sheets are repaired, it would have recovered from the recession much faster and at a much lower cost than the 460 trillion yen or $5 trillion it eventually took to cure the disease.

Corporate savings glut

One of my favorite bloggers, Yves Smith, wrote some weeks ago interesting article about corporate savings glut. Opinion that corporates have big savings can be true, but honestly, is it right to force corporates into savings or tell them what to do with their savings. Plus if they invest more, who will buy their production if households are saving too?

Our New York Times Op Ed on the Corporate Savings Glut: "

Rob Parenteau and I have an op-ed at the New York Times today. Rob’s last post here argued energetically that the now-established trend of the corporate sector to save, as opposed to invest in growth, in advanced economies, and even most emerging economies, was tantamount to capitalists abandoning their traditional role. It reminded me of an article I had written in 2005, “The Incredible Shrinking Corporation,” for the Conference Board’s magazine Across the Board, on how companies were trying to starve themselves into attractive- looking performance though the then-unprecedented act of saving in a time of economic expansion, which is tantamount to disinvestment. Rob’s post made further key points about the macroeconomic implications of corporate savings (given the norm of households savings as well) and made some policy recommendations.

I wish the headline were different (”Are Profits Hurting Capitalism?“), since the article is clearly about the corporate savings glut.

Rob and I thought readers would be interested in the how the draft we submitted compared with the edited version. The draft was titled “It’s the Corporate Savings Glut, Stupid! The Hysteria of Marching to Austeria”:

A series of disappointing data releases in recent weeks, including flagging consumer confidence and meager private sector job growth, is leading more and more experts to worry that the recession in the US and abroad is coming back. At the same time, many policymakers, particularly in the Eurozone, are slashing government budgets, which they contend will lower debt levels, and thereby restore investor confidence, reduce interest rates, and promote growth.

Yet many miss the fact that fiscal deficits are a nearly inevitable result of actions by corporations and households. Failure to understand these dynamics and address root causes is sure to make a bad situation worse.

Unbeknownst to most commentators, corporations in the US and many advanced economies have been underinvesting for some time.

The normal state of affairs is for households to save for large purchases, retirement and emergencies, and for businesses to tap those savings via borrowings or equity investments to help fund the expansion of their businesses.

But many economies have abandoned that pattern. For instance, IMF and World Bank studies found a reduced reinvestment rate of profits in many Asian nations following the 1998 crisis. Similarly, a 2005 JPMorgan report noted with concern that since 2002, US corporations on average ran a net financial surplus of 1.7 percent of GDP, which contrasted with an average deficit of 1.2 percent of GDP for the preceding forty years. Companies as a whole historically ran fiscal surpluses, meaning in aggregate they saved rather than expanded, in economic downturns, not expansion phases.

The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies.

Companies, while claiming they maximize shareholder value, increasingly prefer to pay their executives exorbitant bonuses, or issue special dividends to shareholders, or engage in financial speculation. They turn their backs on the traditional role of a capitalist – to find and exploit profitable opportunities to expand his activities

Some may argue that lower investment rates are the result of poor prospects, but the data does not support that view. Corporate profits have risen as a share of GDP since the early 1980s, reaching unprecedented levels right before the global financial crisis took hold. Even now, US profit margins are nearly two thirds of the way back to their prior cyclical high, despite a subpar recovery.

What happens when corporations on balance are saving, and households in aggregate try to save too? Families and individuals typically tighten their belts and bolster their bank accounts in bad times; the tendency is even more acute now, since many are trying to pay down borrowings, which is a form of saving,

If households and corporations are both saving, it must be balanced by the other two sectors of the economy, the government sector and the import/expert secto. In other words, the foreign and government sectors must spend more cash than they are taking in. In lay terms, that means running a trade surplus and having the government incur budget deficits.

Therefore, when both domestic households and the corporate sector are saving at the same time, then you need to have a VERY large trade surplus, a very large government deficit, or some combination of the two. There is no other way to square this circle – anyone who tries to tell you otherwise does not understand double entry book keeping, which the West has used for at least the last five centuries with some success.

And what if a government embarks on an austerity program in the face of private sector efforts to deleverage? Income growth will stall, and if the austerity program is large or sustained long enough, falling household wages and business profits can result.

That result might not sound bad, since lower wages and prices would make US goods more competitive abroad. But in economies suffering from a debt hangover, as incomes fall, it becomes even harder to make payments on outstanding loans. Defaults and bankruptcies cascade through the financial system, leading to even more reluctance to borrow and lend. In other words, the result of Austerian fiscal policies, is deflation – falling wages and prices – which can easily snowball into a depression.

So rather than marching toward Austeria by pursuing what are being presented as “sustainable” or “sound” spending policies requiring immediate budget retrenchment – and such assertions can only be made by those willfully blind to the interdependence of cash flows at the macro level – we need to kill two birds with one stone. Rather than blindly marching to Austeria, we need to set fiscal policy to the task of incentivizing the reinvestment of corporate profits in business operations rather than games at the casino.

Possible measures to achieve these aims include:

1) an aggressive tax on retained earnings that are not reinvested with a 24 month period after they have been booked (this provision needs to be designed carefully to defeat efforts to circumvent it through artful accounting);

2) a financial asset turnover tax that raises the cost to management (and others) of speculating rather than reinvesting profits in productive capital investment;

3) a reinvigorated public or public/private investment program that helps speed up the shift to new energy technologies (as scaling up usually induces a drop in unit costs of production).

The entrepreneurial pursuit of profitable growth has been the vital engine of prosperity since the Industrial Revolution. Yet incentives for both managers and investors now favor myopia and speculation, undermining the very operation of capitalism. We need tax and regulatory policies to counter this destructive development, along with wider recognition that government deficits are necessary and salutary if the corporate sector is under-investing to boost its short-term profits and households are prudently refusing to increase borrowing to accommodate it.

When both households and businesses attempt to net save, the adoption of Austerian School fiscal policies in highly leveraged economies, is well nigh certain to bring back our grandparents’ experience of debt deflation and economic depression. We must stop and seriously ask ourselves, in whose interest might these Austerian policies be? None dare call it malpractice, malfeasance, or even outright madness

The NYT op ed is here. Enjoy!

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Some more posts about this topic:

One from The Pragmatic Capitalist:

THE FAILURE OF CAPITALISTS TO ACT LIKE CAPITALISTS: 

Yesterday’s discussion regarding Jeff Gundlach’s opinion that the US economy would default raised an excellent question from a reader.  In the article I mentioned that private sector net savings are government deficit.  Steve Randy Waldman at Interfluidity (in a far more detailed look) beautifully described what I was trying to communicate: net household financial income = current account surplus + government deficit + Δbusiness non-financial assets.  The question from the reader was this: if the above equation is true then where is all the private sector surplus?  This question was masterfully answered by Rob Parenteau the other day on Naked Capitalism.  His conclusion:

“Remember the global savings glut you keep hearing about from Greenspan, Bernanke, Rajan, and other prominent neoliberals? Turns out it is a corporate savings glut. There is a glut of profits, and these profits are not being reinvested in tangible plant and equipment. Companies, ostensibly under the guise of maximizing shareholder value, would much rather pay their inside looters in management handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.

What we have here, in other words, is a failure of capitalists to act as capitalists (emphasis added).”

This fact was best portrayed yesterday by Edward Harrison who writes the excellent Credit Writedowns website.  Edward showed us just how much hoarding is going on at the corporate level:

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And one from Alpha Sources.

Botox Economics

Naked Capitalism:"

Botox is commonly used to improve a person’s appearance by removing facial lines and other signs of aging. The effect is temporary and can have significant side effects. The world is currently taking the “botox” cure. A flood of money from central banks and governments — “financial botox” — has temporarily covered up unresolved and deep-seated problems.The surface is glossy and smooth, the interior decayed and rotten

The 2009 ‘recovery’ was based on low or zero interest rate policies (“ZIRP”) of major central banks. Massive government intervention also helped arrest the rate of decline of late 2008/ early 2009. Without government support, it is highly probable that most economies would have been in serious recession. Just as China practised capitalism with Chinese characteristics, developed economies discovered socialism with Western characteristics.

Capital injections, central bank purchases of “toxic” assets and explicit government support for deposits and debt issues helped stabilise the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile.

Further losses are likely from consumer loans, including mortgages. In the U.S. mortgage market, one-in-ten householders are at least one payment behind up from one-in-14 a year ago. If foreclosures (now around 5%) are included, then one-in-seven mortgagors are in some form of housing distress.

Recent stability in U.S. house prices may be misleading reflecting the effect of government incentives (the $8,000 first time homebuyer tax credit) and low mortgage rates driven in part by the Fed’s MBS purchases. The value of 20-30 % of properties is less than the loan outstanding. Home sales remain modest with around 25-30% of sales of existing homes being foreclosures. Housing inventories also remain high in historic terms. With more adjustable rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted unless economic conditions improve.

Rising vacancy rates, falling rentals and declining values of commercial real estate (“CRE”), primarily office and retail properties, are apparent globally. In London, Nomura, the Japanese investment bank, secured a 20-year lease of a new office development on the River Thames – the 12-storey Watermark Place – for £40 per square foot. This was over 40% lower than the rents of nearly £70 per square foot demanded prior to the GFC. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times: “… I’m unlikely to see [the terms] again in my career.”

Banks are likely to remain capital constrained in the near future reducing availability of credit. Commercial and consumer loan volumes have declined reflecting a lack of supply but also a lack of demand as companies and individuals reduce leverage.

The real economy remains fragile. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. The problem remains as government incentives encourage current consumption and investment but ultimately “steal” from future demand.

Employment, a key indicator given the importance of consumption in developed economies, continues to decline albeit at a slower pace. In the U.S., unemployment reached 10%.

In many countries enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen.

Changes in the structure of the labour force also distort the real picture. If workers working part time involuntarily and looking for full time employment are included, the U.S. underemployment figure is in the 16-18% range. Long term and youth employment also remains high.

European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment is a new “export” as guest workers are shipped back to their country of origin or remittances home fell sharply.

In developed countries where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure.

In 2009, global trade stabilised after precipitous earlier falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009 world trade was 8.0% above the low of May 2009 but 14% below its peak of April 2008. Trade protectionism threatens recovery in global trade.

Major risks in the financial and real economy remain and may disrupt the hoped for resumption of business as usual.

From late 2008 onwards, Governments have spent aggressively, going into or increasing deficits, to increase demand within the economy to offset weak private sector consumption and investment.

Financing these initiatives presents significant challenges. In the five quarters ending 30 September, 2009, U.S. Treasury borrowing increased by $2.8 trillion, a rise of around three times from the level of previous years. The U.K. and European countries increased public debt by similar or higher amounts (in percentage terms).

In 2009, investors readily bought large new issues of government debt, despite relatively low interest rates. Rating agencies maintained sovereign debt ratings, especially for major countries despite deteriorating public finances.

Central bank purchases under ‘quantitative easing’(“QE”) (read printing money) programs helped the market absorb the volume of new issuance. According to estimates by Morgan Stanley, Fed purchases of assets, QE programs and other liquidity support programs reduced private sector net purchases of new Treasury issues to $200 billion in 2009. In 2010, in the absence of continued Fed support, private buyers will have to absorb $2,000 billion.

If buyers of sovereign debt pull back, Ireland, Greece and Spain provide an insight into the actions necessary. In order to restore fiscal stability, the Irish government introduced a special 7% pension levy and implemented the toughest budget in the country’s history. Public sector salaries were cut between 5-15%. Unemployment and welfare benefits were also cut. More recently Greece and Spain proposed a program of similar budgetary austerity.

Focus in the short run will be on the ‘PIGS’ (Portugal, Ireland, Greece, Spain) but in the longer term it will shift to major economies with high levels of government debt – the ‘FIBS’ (France, Italy, Britain, States). At least, Japan has its very large pool of domestic savings.

The need to maintain the confidence of rating agencies and investors as well as access to markets may ultimately force the required disciplines. As James Carville famously observed: “I want to come back as the bond market. You can intimidate everybody.” Politicians everywhere will learn the reality in Thatcher’s terms: “You can’t buck the markets.”

The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt. As his friend Dink tells author Joe Bageant in Deer Hunting with Jesus: Despatches from America’s Class War: “Sounds like a piss-poor solution to me, cause they’re just throwing money we ain’t got at the big dogs who already got plenty. But hell what do I know?”

The last few decades have seen an economic experiment where increasing levels of debt have been used to promote high growth. This policy had the unintended consequence of increasing risk in the global economy, which was not fully understood by the individual entities taking this risk or regulators and governments. This experiment is now coming to an end.

The real risk is of long-term economic stagnation. A period of low growth, high unemployment or underemployment and over capacity is possible while individuals, firms and governments repair balance sheets.

Governments and central banks continue to inject liberal amounts of botox to cover up problems, at least, while supplies exist. In absence of any definite solutions, policymakers are deferring dealing with the problems, rolling them forward. In the words of David Bowers of Absolute Strategy Research: “It’s the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments’ assumption of banks’ debts]. There’s nobody left to pass it to in the future.”

The summary of 2009 and the outlook for 2010 may be the logo on a black T-shirt worn by Lisbeth Salander, the heroine of Steig Larsson’s Girl with the Dragon Tattoo: “Armageddon was yesterday – Today we have a serious problem.”

By Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010, FT-Prentice Hall).

EMU break-up risks global deflation shock that would dwarf Lehman collapse, warns ING

Another great story from Telegraph by Ambrose Evans-Pritchard:

A full-fledged disintegration of the eurozone would trigger the worst economic crisis in modern history, devastate every country in Europe including Germany, and inflict a deflationary shock on the US. There would be no winners, warns the Dutch bank ING in a new report "Quantifying the Unthinkable".

"Complete break-up would have effects that dwarf the post Lehman Brothers collapse. Governments would find themselves having to bail out banks again, worsening already fragile government finances. The risk of at least a temporary break-down in payments systems would be enormous, " said the report by Mark Cliffe, Maarten Leen, and Peter Vanden Houte.

"Initial trauma is sufficiently grave to give pause for thought to those who blithely propose EMU exit as a policy option," it said, a rebuke to those German politicians and economists who have talked openly of shaking out weaker members.

The new Greek drachma would crash by 80pc against the new Deutschemark. The currencies of Spain, Portugal, and Ireland would fall by 50pc or more, causing inflation to soar into double-digits. "The impact is dramatic and traumatic," it said.

ING has attempted to unpick the complex consequences of break-up scenarios, concluding that even a surgical exit by Greece alone would hurt everybody, and be suicidal for Greece. Both weak and strong states would suffer violent downturns if EMU unravelled altogether, though each in very different ways. "In the first year, output falls by between 5pc and 9pc across the various former member states," it said.

The German sphere would face a "deflationary shock". The US dollar would rocket to 85 cents against the euro equivalent, with a "temporary overshoot" to near 75 cents. This would tip the US into acute deflation, threatening North America with a double-dip recession. East Europe would contract 5pc in 2011 alone.

Safe-haven flows to core debt markets would drive down yields on 10-year US, German, and Dutch bonds to near 0.5pc, by far the lowest ever. Club Med yields would decouple brutally, rising to between 7pc and 12pc, "capital controls, notwithstanding."

This is the picture of a world falling apart. It is an outcome that Angela Merkel, the German Chancellor, now seems determined to avoid, after dragging her feet over the Spring. The Bundestag has backed Germany's share of the €110bn rescue for Greece, and the €750bn EU-IMF bail-out for future casualties should they need it. The Bundesbank has lifted its de facto veto on purchases of Club Med bonds by the European Central Bank.

Yet markets have failed to stabilise. Spreads on 10-year Greek bonds are still 750 basis points over Bunds. Investors clearly doubt whether the Greek austerity policy of wage deflation can ever work, or whether EU states will back their words with money, or both. The spreads are 285 for Portgual, 272 for Ireland, and 213 for Spain.

The markets perhaps sense that the bail-out battles in Germany are not yet over. There are four complaints lodged at the German constitutional court arguing that the rescues breach EU treaty law and therefore German basic law. While the court has refused an immediate injunction to block aid, it has not yet ruled on the cases.

A group of five professors has just expanded its original complaint against the Greek rescue to cover the EU's €440bn Stability Facility, describing the methods used to ram through the measures as "putschist" and anti-democratic. "This course is leading Germany to ruin," they said.

Germany's Centre for European Politics in Freiburg has joined the fray with a report arguing that the use of €60bn of EU money under Article 122 of the Lisbon Treaty to support the rescue package is illegal. "It is a complete violation of our constitutional law and the judges at the court will have to say so if a case reaches them, even though they are afraid of the economic consequences," said the author, Dr Thiemo Jeck. Bavarian politician Peter Gauweiler aims to file a fresh case along these lines.

ING's global strategist Mark Cliffe said any Anglo-Saxon Schadenfreude at a euro break-up would be short-lived. The UK economy would shrink by 4.5pc from 2011-2012. "It would be a very unpleasant experience," he said.

Safe-haven flows pouring into Britain would drive sterling through the roof. Eurozone demand for UK exports would contract viciously. Pension funds would suffer fat losses on eurozone assets. UK lenders would face havoc again though a web of cross-border linkages.

The Dutch bank does not make any judgement on the merits of EMU, or on whether it is an 'optimal currency area', nor does it explore half-way options such as a split into a hard Teutonic euro and a weak Latin euro.

The report said break-up talk is "no longer just a figment of fevered Anglo-Saxon imaginations". It has spread into top policy-making circles in the eurozone and must now be analysed as a serious tail-risk. A survey of 440 heads of global banks and companies by RBC Capital Markets found that 50pc expect at least one country to leave EMU by 2013, and a quarter expect a complete collapse.

ING said heavily indebted states such as Greece would not gain relief by escaping EMU and devaluing since their debt burden would remain, even if government bonds are switched into the new currency. This is a controversial point. If Greece devalues and defaults as well, the calculus is different. Many big bust-ups entail both, such as the Argentine crisis in 2001. Some Argentines argue that their trauma proved cathartic, pulling the country out of a destructive downward spiral.

If Greek, Portuguese or Spanish leaders ever start to ask their own Argentine questions as austerity grinds on, and unemployment grinds higher, events will run their ineluctable political course regardless of the greater risks.

INGBank Global Economics 20100707

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

The Aleph Blog:

Aggregation of economic variables is required for macroeconomic modeling. One of the largest problems with macroeconomics is whether that aggregation makes sense, or conceals a more dynamic and diverse economy.

The paradox of thrift as proposed by Keynes assumes that all saving is similar. People invest excess monies in some simple depositary instrument that earns interest. As people panic over bad economic activity, they save more, driving interest rates lower. But wait. What if they don’t place their money in depositary instruments? What if they pay down debt, whether secured or unsecured? In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises. The liquidity crunch at the banks will lessen. Or, people may save in a different way, by:

• Buying gold, commodities, or non-perishable consumables
• Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
• Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment. The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment. Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater. Some firms even borrow long-term to have cash on hand. It’s a negative arb, but it gives the firm flexibility. But even firms may have alternative ways to save:

• Investing in labor-saving or waste reducing technology.
• Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
• Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks. There are many ways to save, and there are always alternative uses for money. Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil. The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift. There is only one type of labor. Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale. Big deal.

But labor is different. We have the ability to choose different firms to work at. Not all work is equal, and there are often better and worse opportunities available for labor. Recessions occur partially because capital and labor are misallocated. Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm. Find a problem that irritates many, and solve it. Create a product or service that meets the needs of many. In a deflationary environment that might mean finding a cheaper way to do things. But it could be creating a new product that meets needs that people or businesses did not know they wanted. Go for a Blue Ocean Strategy.

The best businesses are often created in recessions. Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil. They are bogus results of oversimplified models that do not reflect reality. As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market. If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

• The dot-coms of the late ’90s
• The one decision stocks of the ’60s.
• Gold in the ’70s.
• Railroads in the late 1800s.
• Buying stocks in the 1920s.
• Selling stocks in the 1930s.
• Selling bonds in the early ’80s.
• The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already. The main point is the same. Anytime everyone does the same thing, it is foolish. It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets. That does not mean that foolish people will not get hosed. That’s the nature of being foolish. But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

• Stimulus programs that don’t produce economic value. If it only pays a wage, that is destructive. For stimulus to be effective it must produce infrastructure that lowers the costs of the economy. Think of all the useless projects built in Japan.
• Paying extended unemployment benefits. Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
• Running large deficits. If the money is not being spent on something that will produce future growth, it is a loss.
• Bailouts of large financial institutions. We have too many of those.
• Housing tax credits. We have too many houses.
• Bailing out auto companies. Too many autos are made in our world today.
• Bailing out the GSEs. They are deadweight losses. Let them die, and let the senior bondholders feel the pain. Let the junior bondholders be wiped out.
• Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy. A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing. Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage. They have had two lost decades, and are starting on their third lost decade. Is that what we want?

Those low interest rate U-Zirpers at the BIS

FT Alphaville:

Those low interest rate U-Zirpers at the BIS

Posted by Tracy Alloway on Jun 29 08:15.

In the battle between Austerians and Stimulants, the Bank for International Settlements (BIS) knows where it stands. In its latest annual report the central banks’ bank takes aim at everything from delayed fiscal adjustments to the extended period of low interest rates in places like the UK and US.

The whole thing reads like a confirmation of every risk you might have suspected, to date, could accompany extended loose and unconventional monetary policy. It’s BIS’s job to identify risks, of course, but seldom are they so . . . forthright, or wide-ranging. Rage against the Zirp, dear BIS.

The summary:

. . . policymakers will need to consider the distortions caused by prolonged conditions of monetary ease. After all, sustained low interest rates have been identified by many as an important factor that contributed to the crisis (see BIS, 79th Annual Report, Chapter I). At the same time, policymakers should also closely monitor the distortions arising from unconventional monetary policy tools. These include price distortions in bond markets that can result from changes in central banks’ criteria for eligible repo collateral and from their asset purchases. Artificially high asset prices in certain markets might delay the necessary restructuring of private sector balance sheets. There are also distortions in market activity that arise from central banks’ increased intermediation during the crisis. Moreover, the asset purchases have exposed central banks to considerable credit risk, which together with the changed balance sheet composition may expose them to political pressures.

History offers little guidance on the economic significance of the side effects of unconventional monetary policy. By contrast, distortions arising from low interest rates have been observed in the past. In this chapter, we review these risks in the current context and argue that, if not addressed soon, they may contain the seeds of future problems at home and abroad. In doing so, we draw on lessons from the run-up to the financial crisis of 2007–09 and on Japanese experiences since the mid-1990s . . .

Uh oh — subprime and the Lost Decade? You know what’s coming — a rather stunning indictment of certain current central bank policies. Some choice bits recounted below, with our highlights.

For a start, the risks of that steep yield curve:

Low policy rates in combination with higher long-term rates increase the profits that banks can earn from maturity transformation, ie by borrowing short-term and lending long-term. Indeed, part of the motivation of central banks in lowering policy rates was to enable battered financial institutions to raise such profits and thereby build up capital. The heightened attractiveness of maturity transformation since the crisis was reflected in rising carry-to-risk ratios in 2009 and early 2010 (Graph II.1, bottom right-hand panel). Increasing government bond yields, caused by ballooning deficits and debt levels and a growing awareness of the associated risks, make the yield curve even steeper and reinforce the appeal of maturity transformation strategies.

However, financial institutions may underestimate the risk associated with this maturity exposure and overinvest in long-term assets. As already noted, interest rate exposures of banks as measured by VaRs remain high. If an unexpected rise in policy rates triggers a similar increase in bond yields, the resulting fall in bond prices would impose considerable losses on banks. As a consequence, they might face difficulties rolling over their short-term debt. These risks may have increased somewhat in the aftermath of the 2007–09 crisis, because the poor credit environment for banks and the greater availability of central bank funding have left many banks with funding structures skewed towards shorter maturities. A squeeze on banks’ wholesale funding might set off renewed asset sales and further price declines.

On extend and pretend, or the ‘evergreening,’ of loans:

One legacy of the financial crisis and the years preceding it is the need to clean up the balance sheets of financial institutions, households and the public sector, which finds itself in a poor fiscal position, partly as a result of the rescue measures adopted during the crisis. Low policy rates may slow down or even hinder such necessary balance sheet adjustments. In the financial sector, the currently steep yield curve provides financial institutions with a source of income that may diminish the sense of urgency for reducing leverage and selling or writing down bad assets (see also Chapter VI). Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency.

Past experience has shown that low policy rates allow “evergreening”, ie the rolling-over of non-viable loans. During the protracted run of low nominal interest rates in Japan in the 1990s, banks there permitted debtors to roll over loans on which they could afford the near zero interest payments but not repayments of principal. Banks evergreened loans instead of writing them off in order to preserve their own capital, which was already weak due to the earlier fall in asset prices. This delayed the necessary restructuring and shrinking of financial sector balance sheets. Moreover, the presence of non-viable (“zombie”) firms sustained by evergreened loans probably limited competition, reduced investment and prevented the entry of new enterprises.

And the international side effects of the search-for-yield:

Capital flows allow a better allocation of economic resources, and inflows are important contributors to growth, especially in emerging market economies. In the current situation, however, they may lead to further asset price increases and have an inflationary impact on the macroeconomy. They have also caused an appreciation of those target currencies that float, which corresponds to a tightening of monetary conditions in those countries. Nevertheless, further interest rate increases seem likely, and these may attract even more funds from abroad. This exposes the receiving economies to the risk of rapid and large capital outflows and the reversal of exchange rate pressures in the event of a change in global macroeconomic, monetary and financial conditions or in investors’ perception thereof. Chapter IV discusses the issues associated with capital flows to emerging markets in more detail.

The major worry then is what happens should these government efforts fail. All of their policies — Zirp, quantitative easing, debt forbearance, etc. — are predicated on the idea that markets just need time to start functioning again. That has so far not happened and, in the meantime, central banks are stuck.

As BIS puts it:

Unlike [in 2008], however, we have hardly any room for manoeuvre. Policy rates are already at zero and central bank balance sheets are bloated. Although private sector debt has started to decline, public debt has taken its place, with sovereign fiscal positions already on an unsustainable path in a number of countries. In short, macroeconomic policy is in a vastly worse position than it was three years ago, with little capacity to combat a new crisis – it will be difficult to find a source of further treatment should another emergency arise. Regaining the ability to react to economic and financial crises, by putting policies onto sustainable paths, is therefore a priority for macroeconomic policy.

Crikey. That’s quite a lot for so early in the morning.