For the Millennials, The Social Security Chickens have Come Home to Roost

1965 was a momentous year for the US. LBJ, the newly elected President, was in a bind. He had objectives that required spending, which would generate a fiscal deficit —and, in turn, more government debt. But coming out of WWII, fiscal deficits were considered to be taboo by both political parties because they would further add to wartime debt accumulation.

The game plan, which should again be considered today, was: Don’t add more debt. Instead, grow the economy without additional government fiscal deficits. The plan implied having a balanced federal budget, while still growing income to service the debt load. (No doubt, the subject of a future blog.)

So the challenge for LBJ was to escalate the Vietnam War effort and make good on expensive campaign promises (called the “The Great Society”) all while running a balanced fiscal budget.

The Great Society was multi-dimensional but, most important, involved entitlements on a grand scale that included the expansion of Social Security and the introduction of Disability and Medicare.

So what came of it was perhaps the beginning of the government ethic to vote for whatever America wanted and to find a way, however devious, to finance it.

A way was found, and it’s still used today. The Federal Government would raid any pot of taxpayer money set aside for another purpose and spend it — and then cover it up.

How it is done is most easily understood with an analogy: A family is attempting to provide a college fund for its children. The children work while in high school and contribute to the college fund cookie jar each week. So do mom and dad. Except dad, exercising his sovereign oblige, dips into the cookie jar regularly to pay for whatever seems more pressing at the time. In return, he leaves a note — an IOU — to be due when funds are needed for their stated purpose.

Dad’s IOU does not appear on his balance sheet, but when college expenses need to be covered, he goes to his friendly bank for a loan to make good on the funds he raided. The loan from the bank provides the funds to retire his IOU but the bank loan goes on dad’s balance sheet. It’s a market transaction and adversely affects dad’s credit rating and the cost of borrowed funds from outside the family.

This is the general mechanics of what has occurred on a grand scale with the social insurance trust funds. The particular pot of money most tempting for the government to raid for other use was the Social Security “trust” fund.  That’s because it was large and growing, at the time, as the Baby Boomers were just entering the labor force hence contributing to the Social Security trust funds via the payroll tax.

What made Social Security funds even more a target was that the great majority of the beneficiaries wouldn’t be scheduled to receive promised benefits for decades. That is, the missing funds not be missed for some time.

In order to raid the trust funds and cover it up gracefully, the government used an accounting sleight of hand. The Federal budget (in deficit) was consolidated with the Social Security budget (in surplus). This gained access to the unspent social security trust inflows to be spent on non-Social Security items. Furthermore with deficits and surpluses offsetting, the consolidated budget was near balanced affording the politicians the ability to claim fiscal responsibility to boot.

Hence with the surging Baby Boomer contributions of young workers exceeding the payouts to those retiring, the good ol’ government would spend the bonanza on the pressing wishes of the day. As the Treasury confesses (page 6):

“When revenues in the trust exceed benefit payments, the unspent monies must remain in the trust fund for future use. However, this excess cash is transferred to the Treasury’s General Fund and is used to finance other activities which fall outside the specific purpose of the trust fund.”

To give you an idea of the intent to cover-up the transaction, when Social Security cash was used by the Treasury for general purposes, the IOU placed in the fund was a new category of government debt created for the purpose of the cover-up. It is called “special debt,” not to be confused with “market debt,” a distinction the Treasury maintains.

The reason is special debt isn’t reported on the federal balance sheet and, in today’s financial nomenclature, is referred to as “off-balance sheet” debt. In other words, hidden debt.

The special debt is basically an IOU just like dad’s which is not sold on the market. Nor is it accounted for on the government balance sheet. This means the special debt issuance does not affect the market pricing of debt, nor the tally of debt on the government’s books and it is effectively below the radar when it comes to the market appraisal of the riskiness of the government debt load.

The raiding of social security trust funds and its cover up has worked smoothly behind the political and accounting scenes for a half century. But alas, with the arrival of the Baby Boomers at the trust fund window to claim benefits, at least one category of trust funds, the Disability Insurance fund is now running negative cash flow.

Like dad, the government needs to make good on the cash-call to pay the benefits and has begun to borrow the funds with on-balance sheet US Treasury debt.  At this point in time, the chickens have finally come home to roost.

These days, the annual increase in government market debt now covers not just current fiscal deficits of the government but also covers the cash call for the special debt. For example, in the most recent fiscal year, the government fiscal deficit was $575 billion, but US Treasury debt sales were $1.3 trillion (which is not a trifiling matter.)

Hence, we have entered the era when government debt accumulation is greater than the already-large ongoing federal deficit. Ultimately, it will adversely affect the market’s perception of the riskiness of US government debt as it piles up.

All this might seem like a fairytale gone badly but unfortunately it’s not a fairytale. But realize, it could have been avoided and can still be avoided for the millennial generation. It’s not too late for them to actually have a funded pot, with money that could grow for decades while invested in the private sector, when it’s their time to claim Social Security.

Such is the state of Social Security in countries that actually invested the funds in the private economy. Chile was the pioneer and was more or less followed in Latin America. It’s called “privatization” of Social Security. The trust funds have basically been invested in private sector funds that included private sector debt, a stock market index fund, and a foreign stock index fund, in addition to a government bond fund.

These funds, decades later, are paying out two to three times more than the payouts originally scheduled through investing in government bonds. If the private funds do not outperform the scheduled Social Security payout, the government would make up the difference — but that has never been necessary.

If funds contributed in, say, in 1970 had been invested in an S&P index fund, they would be redeemed today at about an 8 to 1 ratio as compared to the contribution at that time.

Providing for Social Security in this manner has other important benefits as well. Social Security contributions would be financing business sector expansion as opposed to government spending.

 Moreover, workers would have a stake in the growth of corporate stock valuations and this would serve to reduce the contentious economic and political divide that exists in the US.

As it stands, the millennials social insurance contributions will fund the retirement of their parents’ generation and when their funding is insufficient they will have to support via higher taxes, a higher government debt load over their lifetime. 

You millennials, it’s time to make your voices heard. Pass it on.

 

Does Mega Money Result in Dead Weight Debt?

Mega Money, which is a large scale increase in the monetary base, creates unease — if not fear — among market participants. The fear is that it will lead to a cycling upward of prosperity and inflation, followed by an equally sharp downturn of both. Many have moved to the investing sidelines as a result of the uncertainty. They are alarmed at the prospects for a down-cycle because classroom theory or personal observations have taught them to expect it.

In academics, Mega Money creates an expectation for some version of “runaway inflation” whether based on neoclassicist, Austrian School, or monetarist thinking. Generally, it is taught that inflation is proportionate to the money surge.

But it should be understood that this version of the money-inflation linkage occurs when governments print money as a means to purchase goods. That is, the money is directly inserted into the economy’s spending stream, creating demand and higher prices as happened, for example, during the Civil War.

This is in contrast to today’s Mega Money, which has been inserted by central banks into financial asset markets as opposed to the direct route of inserting money into the goods market. So the effects of Mega Money, for better or worse, arise out of financial market purchases, which some might characterize as having inflated asset prices.

The Mega Money process is that central banks purchase assets from private investors, and those investors, in turn, take the proceeds and purchase some other private sector financial claim that feeds some ventures with capital.

If the Mega Money is the result of central bank expansion, firms finance some activity, usually via credit market instruments (bonds or loans, etc.). So when credit-financed spending takes place, in things like plants and equipment, there is a short-term impact that generates spending, income, and jobs. The same can occur via the consumer sector where the credit funds investments in durables, such as autos or homes.

This is short term in nature and might generate some inflation if those goods are in short supply. This describes the classic Keynesian rationale and process of employing monetary policy to stimulate an economy.

However, the longer term impact of the money created depends crucially on whether the capital spending creates an income stream to retire the debt that was incurred in the process. If the debt-financed investments generate additional cash flows to retire the debt over time, and if it continues to generate additional cash flows, it become a gift that keeps on giving.

But if the use of the credit doesn’t generate cash flows to retire the debt, then its longer run influence is adverse because the debt is paid off from future income rather than from the underlying earnings of the investment undertaken.

To coin a term, this is Dead Weight Debt. It sounds bad, and it is. Dead Weight Debt compromises future income, and the usual cyclical responses are negative. That is to say, expect recessionary forces and all that goes with it: Less spending, lower income, less employment, lower market values of financial claims, deflation, and so on.

For example, consider the classic case of the housing boom (ending in 2007) and the subsequent bust: Easy money built houses which did not create its own income stream to retire the debt. It compromised future spending, creating The Great Recession and deflation instead of inflation.

This same issue arises today, post-election. The US government is contemplating major debt-financed infrastructure investments. Will the investment generate revenue streams to more than retire the debt incurred, or will it be Dead Weight debt that compromises future economic growth? This is the difference between a short-term positive lift vs. a longer term contribution to economic growth.

So the result of the central bank’s Mega Money depends on either the public or private investment returns it finances. If the returns are positive, taking into account the debt retirement, it can lead to sustainably higher growth rates — but if negative, it creates Dead Weight Debt, which is recessionary.

Take a look at how uncommon Mega Money episodes are in the US. The monetary base is shown from 1956 on forward. It reveals very steady growth with but a minor blip until 2009.

Then the monetary base rose, and it should be safe to say dramatically, as the increase over the following five-year period (2010 to 2014) was nearly 100 times the annual increases from the immediate prior years.

That is to say, the Mega Money buy was the near equivalent of a century’s worth of buying.

picture2

So the question we have to ask today is, did the Mega Money-financed buy set up Dead Weight Debt that will become a burden on economic growth, or is the debt self-sustaining and will it contribute to future growth?

Since over that Great Recession time period it helped finance more than a doubling of US government debt outstanding, most of that debt must be argued to be Dead Weight as it didn’t create income streams.

The consumer sector did not participate in the temptation of cheap interest rates to add further debt and, in fact, continues to net pay down debt incurred in the housing boom.

But the corporate sector, it must be realized, participated heavily in borrowing from the Mega Money liquidity. Below shows the ramp up of Non-Financial Corporate Debt since just prior to the Great Recession.

picture1

The total amount of debt securities by the corporate sector rose from a base of $3.4 trillion, just prior to the Great Recession, to near $5.6 trillion. If you add in the growth of commercial and industrial bank loans of another $.7 trillion, the business sector debt gets above $6.3 trillion combined.

Much of this ramp-up of corporate borrowing was incurred at the extremely low interest rates that prevailed in the course of the Mega Money expansion. However, the funds were generally used by the borrowing businesses to repurchase its own equity shares off the secondary market. The purpose, then, of the transaction was to augment earnings on a per share basis rather than in total.

Manipulating higher earnings on a per share basis by leveraging up the corporate balance sheets has to be the very essence of Dead Weight Debt. It contributes no income to retire the debt. Moreover, refinancing the debt at maturity means the interest carry costs will rise substantially at that time.

Interest rates have made their turn upward from all-time lows in July of this year. This means that debt service for the corporate sector will be rising, especially for those with junk ratings (as the default experience by junk rated firms is already moving up from 1.7% in the spring to north of 5.6% presently). Cash flow strains are hitting the business sector and will increase in the years to come when more debt is refinanced at higher interest rates. It will have adverse effects on corporate earnings and spending and market valuations.

So in evaluating the effects of Mega Money, the question to ask is, does the Mega Money finance productive investments that have led to increased income streams to retire the debt incurred? If not, Dead Weight dead is paid for with reduced future income.

This represents an important qualification from Keynesian thinking in which all monetary and credit expansion is thought of as always having a positive income payoff. This is a consideration that the Federal Reserve needs to grasp. Mega Money can lead to a depression if it creates enough Dead Weight Debt.

So far, almost nothing in this episode of Mega Money has been typical, certainly not as compared to the neo-classical outcomes of Mega Money turning into goods inflation. The stimulus phase of this episode of Mega Money financed energy and commodities investments at a cost to those who financed it. That is these investments didn’t create sufficient income streams. The gain was short term.

Mega Money has increased business leveraging and is starting to unwind. Will it be sufficient to take the specific companies down, and will it take the economy down along with them into a generalized recession? That remains to be seen.

Stay tuned to TheSpelllmanReport.com to receive an ongoing heads-up on this and other issues of the economy and financial markets.

In The New Monetary Ballgame, the Game Is Rigged for US Treasuries (Part 2)

Every financial debacle that takes banks down is an open invitation for governments to impose regulation with the aim of preventing a reoccurrence. The financial crisis of 2008 was no exception.

Unfortunately, revisions in the banking environment generally end up with unintended consequences, and they are far-reaching.

The regulation in question are designed to reduce a banking system vulnerably to being caught with insufficient liquidity in a market-driven flight to cash. (It’s something that Deutsche Bank no doubt should be thinking about at this time.) All this is explained in Part 1 of The New Monetary Ballgame, which is a deep dive for those most interested.

But in brief summary, the Bank for International Settlements (BIS) — the central bank for central banks — is imposing liquidity and solvency criteria on the banks for all member countries of the G-20. This is being imposed because the financial crisis of 2008 was worldwide, and now all member governments have accepted the BIS’ dictates.

The immediate thrust of these regulations is to impose substantially higher liquidity requirements on banks. The purpose is to allow banks to retire all bank claimants who want out if a bank run à la 2008 were to occur. Liquidity means being prepared with cash. And if not, banks are forced to sell assets en masse. This could create a far-reaching financial selling crisis, which in turn forces governments into the financial rescue business.

In this new monetary ballgame, banks can choose from a menu of assets set out by the BIS to satisfy the new and higher liquidity requirements. Obviously, cash on hand or deposited with a central bank (not necessarily their own) qualifies. In addition, the BIS wants these assets to be interest-bearing so as not to sacrifice bank profitability in the quest for more liquidity. As a result, some marketable interest earning assets also qualify for the liquidity requirement. But which?

In general, the preference is for banks to hold interest-earning assets for which there is a robust secondary market that could turn those assets into cash with little discounting during a financial crisis.

This narrows the potential candidate assets very quickly because most assets substantially decline in value in secondary markets in the midst of a financial crisis. Hence, what banks need in a selloff is what market traders refer to as “flight to quality assets.” In regulatory jargon, this is now being expressed as High Quality Liquid Assets (HQLA).

Certainly highest in the pecking order among HQLA would tend to be sovereign bonds and perhaps highest quality corporate or muni bonds, with the regulators permitting.

And that is the way the discussion rolled out with the European members nominating their own country bonds to be considered HQLA.

But you can image what followed when, for example, Greek sovereign bonds with a Moody’s Rating of Caa3 would have become eligible to meet the HQLA requirement. As could be expected, the US objected. In its opinion, only US Treasury securities qualify to be HQLA for all countries’ banks.

While on the surface this appears to be an argument about bond quality, at the Machiavellian level this is an argument over whose bonds will be imposed on the banks of all the G-20 countries. Result? The US won. Banks from all G-20 countries can now satisfy their BIS liquidity requirements by holding US Treasuries.

So when the global bank regulator can, under the guise of “safety and soundness,” impose an incentive to hold US Treasury obligations, it has established a mechanism to finance US government debt at lower yields than would otherwise be the case. That comes just in time if you ask me, as the US structural deficit has widened to $0.6 trillion/year with decades of rising baby boomer entitlements staring us straight in the eye.

So you can see the advantages involved from winning the Machiavellian jostle and be deemed, the king of sovereign debt issuers. The US sovereign bond prices will be higher and the yields will be lower. Indeed, over the summer, the 10-year US Treasury yield fell to its all-time low of 1.37% just as banks across the G-20 were approaching the September 30th deadline to fulfill their new liquidity requirements.

In comparison, the BIS allowed US investment corporate grade debt to be counted as bank liquidity but with only a 50% weight. That is to say, anticipate that corporate debt would sell in the market during times of stress at a 50% discount. Not bad when you realize that even investment-grade US municipal bonds receives a haircut of 100% in the calculation of its contribution to bank liquidity. Thus municipal bonds clearly lost out in the Machiavellian jostle as none of it counts for bank liquidity.

As a result of this weighting, the market yield spread has widened between assets classes such as US Treasury bonds and investment-grade muni bonds. With muni debt having less regulatory value, their yields have risen relative to those of the US Treasury that does have regulatory value.

What is yet to come over the next two years is higher ratios of equity capital for commercial banks. This means banks will need a larger amount of their own banks’ stock on their balance sheet to increase their net worth and ability to take asset losses without going insolvent.

But every additional share sold dilutes existing stockholders’ claim on banks’ profits. When substantial increases in bank equity capital need be raised, especially at times of very low market pricing of bank equity, it will take a lot of shares at low prices to raise the required amount of additional bank capital. This will dilute existing shareholders into a nothingness.

But in this rigged game, there is an alternative to bank stockholder dilution: Hold larger proportions of US Treasuries as assets and, since they are anointed by the regulatory to be “riskless,” a bank has less need to protect itself from losses as the regulator claims those assets will not deteriorate in value. Hence, the regulatory mandate for higher equity capital is waived against those assets by holding more US Treasury obligations!

The result is that yet more G-20 country banks, especially weaker European banks, will add to their holdings of US Treasuries rather than dilute their existing stockholders via the sale of a ton of additional bank stock.

It’s so obvious, one doesn’t need to take a step backwards to get perspective. When assets must be bought and held by developed world banks which are a very large asset pool (a multiple larger than central bank assets), it generates considerable demand for that asset that doesn’t go away. It becomes a rigged game because the price of the issuers’ debt is supported in the market and the issuer’s borrowing costs decline.

In turn, it encourages the subsided issuer to keep issuing more debt.

Therefore, it’s no great surprise that we find ourselves at a point where the developed world countries are talking about issuing yet more country debt and spend the proceeds as the way to generate more aggregate demand.  This would constitute a shift toward fiscal policy and away from monetary policy to manage a depressed economy.

Another major implication is that the textbook treatment of interest rate determination based on investor queasiness from inflation and default still remain. But those influences on interest rates pale by comparison to the fiat demand generated by G-20 commercial banks for US Treasury securities.

Stay tuned. It’s a new ballgame, and we’re going to have to relearn many of the things we thought academics and history had taught us. 

 

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It’s a Whole New Ballgame: The Fed Has Been Stymied: (Part 1)

As a result of the 2008 financial meltdown, The Bank for International Settlements (BIS) was tasked by the G-20 countries to change the global rules of commercial banking in order to prevent a re-occurrence. Their mandate was: no déjà vu again, if you please.

The snuffing-out of future financial crises comes via regulation, and because regulation tinkers with the equations of the “system,” it changes the built-in reactions. This requires us to rethink what we presume will occur.

For example, it turns out that when the BIS tinkers with things to make banks more resilient to meltdown, it also makes them more resilient to monetary expansions. So this explains, in part, why even though the Fed increased its balance sheet by 500% since 2008, US commercial bank balance sheets have increased by only 45%. And since commercial banks provide credit directly to businesses and individuals, the (lack of) banking and in turn economic expansion has disappointed most observers — including the Fed itself.

Before getting around to explaining how that can happen, first, some background on the dynamics of a bank meltdown. This will provide you with an understanding of what the regulators are tinkering with and why, and then what the consequences will be.

Bank runs follow a typical scenario, and 2008 was a classic example. It starts with a loss of confidence in the banking system’s assets sufficient to cause bank depositors and other providers of short-term bank funding (deposits and loans) to exercise their right to exchange their claims on the bank for immediate cash.

This, in turn, forces banks to sell assets into the market to obtain cash in order to be able to “cash out” these bank claimants. The selling of bank assets must meet the pace of the demanded cash, and if the depositors and lenders aren’t mollified, it can turn into an asset fire-sale in order to obtain the needed cash quickly.

Cash is king in a bank run, and banks in need are willing to swap assets at a discount in order to obtain it — which is what causes a banking crises to become a financial crisis. These twin crises are two sides of the same coin.

It quickly occurs to depositors and claimants (even those affiliated with banks thought to be “solid”) that their banks’ assets are being compromised in market value by these fire-sales. This, in turn, causes the depositors of the “solid” banks to become jilted out of their comfort zones and to demand cash as well — just in case.

From there, the run affects those banks thought to be doing well.

Note that the first sparks in the financial meltdown are due to obtaining liquidity, but it quickly turns into a question of “is my bank still solvent?”

Solvency is the basic issue of whether my bank’s assets now exceed its liabilities so that it can cash out all claimants if need be. If not, the regulator might even beat the depositors to the punch and seize the bank in anticipation of an insolvency, which they can do. And they can be quick on the trigger because they suffer the residual losses if they guarantee the bank’s debt.

In that case, claimants then worry whether the resolution and liquidation of the bank calls for their claims on the bank to be bail-out or “bailed-in,” with the latter occurring more frequently these days.  All this increases the uncertainty and fear by bank claimants as to whether they will be made whole.  This then increases their propensity to more quickly cash out their bank claims when questions of illiquidity or insolvency arise.

For any reader that saw The Big Short, this should sound familiar. That movie depicted the moment in 2008 when investor and regulator focus turned to the solvency of Bear Stearns. Its stock price went into free-fall, and its claimants wanted their cash back. It was immediately over for Bear Stearns (forced merger with JP Morgan Chase), and the only remaining question as a claimant was, would you be bailed-out or bailed-in?

So it’s with this background that one could imagine the importance of reducing the vulnerability of the trifecta of risks: bank runs, financial meltdown, and an economy that gets sucked down by the implosion of the market value of wealth.

As you now see, bank and financial crashes are the result of depositors running to cash out, so perhaps you can imagine what the BIS is requiring of banks in the G-20 countries: Hold a higher proportion of cash or assets that can quickly be sold with little discount in a period of financial distress.

These requirements are spelled out in the new lexicons of banking called Liquidity Coverage Ratio or LCR. It defines the amount of cash and cash-type assets that banks must hold. The LCR is specific to each bank and is intended to cover the bank’s 30-day forward net cash needs in the course of doing business under financial stress.

To have adequate liquidity in financial distress, there is a greater emphasis on cash as the asset of regulatory choice, so there is no need to actually sell an asset to obtain cash during a financial crisis. Actually, the emphasis is even more narrow on cash in excess of what banks would be required to hold under country-specific banking laws.

It turns out that holding excess cash deposited with a central bank has great appeal to the banks as well to satisfy its BIS liquidity requirement. But let’s be clear: For the cash to be available to cash out a bank’s claimants, it must be in excess of the minimum cash amounts that country banking laws already requires banks to hold.

The BIS liquidity requirement is on top of the Fed’s cash requirement.

But there is a problem with holding excess cash to meet the liquidity requirement. In several G-20 countries, excess cash deposited at its central bank has a net charge called a negative deposit rate. For example, the European Central Bank deposit rate for its banks is -40 basis points, and marginal excess reserve deposits in Japan are at -10 basis points. The required liquidity comes at a high cost because negative deposit rates do not produce positive earnings.

One should quickly realize that because the Federal Reserve Bank pays a positive 50 basis points on cash reserves, banks across the G-20 would prefer to hold excess cash at the US Federal Reserve instead of at their own central banks — and foreign banks can do that by making deposits at the Fed via their US subsidiaries.

Here’s the implication: There is a substantial need and incentive for banks not only in the US but also across the G-20 to hold excess US dollar cash reserve deposits at the US Federal Reserve Bank.

Below is shown total cash reserves at the Fed and its division between required and excess cash amounts, starting just prior to the financial meltdown. The total cash owned by banks rose starting with post-financial crisis QEs. Total cash derives from the Fed buying assets and paying in currency (or claims that can be converted to currency) and that cash, in turn, being deposited by the seller at his or her own bank.

By US banking law, the portion of cash from that transaction that is required is a rather small proportion of the deposit. So in total, the new cash becomes divided between required cash (shown as the narrow strip in brown at the bottom of the graph) and the “excess” of what is required.

The amount of excess cash, shown in blue, is large in absolute and relative terms ($2.37 trillion, presently) as compared to a normal level of zero held for many prior decades.  That is, banks were fully loaned up given the cash amounts provided by the Fed and all cash was required.

It’s a Whole New Ballgame

This condition of excess bank cash has, since Keynes’ time, been characterized as a “liquidity trap.” It was taken as synonymous with depressionary circumstances where borrowers did not wish to borrow and lenders did not wish to lend, causing high proportions of excess cash.

But now, there is a new incentive for banks (and not just US banks) to hold excess US cash. It meets the BIS liquidity requirement while also being paid 50 basis points by the Fed. From the bank’s perspective, that is a decent return on riskless paper that cannot depreciate due to falling bond prices, which typically occurs when they need the cash most — i.e., in a financial meltdown. It’s a reasonable way to meet the LCR requirement.

So if an individual commercial bank needs to meet its LCR, it sells assets and deposits the proceeds with the Fed. It would not be putting the cash into loans and paying for the loan with deposits (the usual commercial bank money expansion method) because the deposit would create the need for the bank to use some of its new cash as required reserves and it would not contribute to its LCR requirement.

This is hardly a prescription for monetary policy to generate lending and spending to achieve the macroeconomic objectives of job growth and inflation.

So now, hopefully you see the irony. Though the Fed has embarked on multiple quantitative easing operations of expanding its balance sheet in order to stimulate commercial bank lending and spending, it’s not happening to the extent it would have formerly occurred.

It is the increased need to hold cash, as dictated by the BIS liquidity requirement, that causes banks to hold excess cash rather than lend it out. This is what is creating the liquidity trap. And it’s not just true for US banks: Cumberland Advisors estimates that 44% of the excess US bank cash held at the Fed is in accounts belonging to US subsidiaries of foreign banks.

It used to be that the money supply multiplier concept gave testimony to the importance and strength of monetary policy. It had been the case that when the central bank printed money and bought assets, credit availability would get a boost from these central bank purchases, but the far greater boost came from commercial banks’ subsequent expansion of loans. This has been called the money supply multiplier because banks expanded credit in amounts 8 to 9 times the Fed’s increase in its asset purchase.

That is quite a money supply multiplier.

This multiplier gave the Fed and its monetary policy an extraordinary influence on credit availability and a much greater impact on the economy than it would have had through its own direct purchase of assets.

It’s a Whole New Ballgame

Thus, in today’s discussion of why the Fed’s expansionary policy is not reviving the economy, one need look no further than the banks’ muted response to it. The accompanying graph shows the growth of US commercial bank assets since 2008.

The Federal Reserve balance sheet has expanded 500% since the pre-financial crisis times of 2008 via Fed QEs, while the combined bank balance sheets have increased only 45%. Or to put it another way, if the responses of commercial banks to the Fed expansion were in the same proportion as the pre-financial crisis relationship of commercial banks and Fed balance sheets, the combined commercial bank assets today would be $55 trillion vs. its actual level of $l6 trillion.

To understand how under-expanded and under-loaned banks are, realize that half of the commercial bank expansion is not due to additional loans but rather to banks holding the additional cash the Fed spent on assets that then became deposited at the sellers’ bank.

So the Fed’s influence on growing credit and on the economy has largely been stymied by the new required liquidity amounts — all with the goal of averting the next financial crisis. And the press hoopla about what the Fed will do next has become a carnival sideshow that embarrasses the Fed because when it steps on the monetary accelerator, very little happens.

What the Fed needs is a low PR profile for its own good when it comes to its ability to restore full employment and inflation. It creates false expectations that can’t be realized while there is a BIS liquidity requirement that’s neutralizing its expansionary policy.

What we have is a situation in which regulators with different mandates are working at cross purposes with each other, with the BIS forcing cash holdings (and other liquid assets) to prevent illiquidity in a crisis, and the Fed providing cash with the hope that banks lend it and borrowers spends it.

The Fed giveth, and the BIC taketh away.

The bottom line is that the Fed (and other central banks) have supplied cash, but much of it has been hoarded to make sure bank runs and financial crises are a thing of the past. So if the Fed were to provide economic stimulus consistent with its objectives, it needs further expansion rather than the “normalization” of its balance sheet to 2008 levels.

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The House of Cards: EU Edition

It’s been an implicit theme of this blog that ultra-low interest rates, even into negative territory, pursued by economically failing developed countries, are more a problem than a solution.

Allow me to make that explicit.

The policy derives from a complete and exclusive focus on Keynesian thinking: The lower the cost of credit, the more of it will be sought and used to finance spending for consumer durables and capital equipment. This in turn might generate income and jobs. With capital investment prospects being painfully limited (which is the problem not being addressed), the enticement of low interest rates, even at subsided (negative) rates has had a meager advantage.

However, negative rates are undercutting financial intermediaries. This will only create major disasters that governments will have to underwrite.

Basically, no financial intermediary would seek to place a loan or purchase a fixed income instrument at a negative rate unless they were forced to do so. That force is called financial regulation. Simply put, negative rates do not generate investment income. Therefore, the financial intermediaries — be they banks, credit unions, pension funds, or insurance companies — will be unable to perform on their obligations to their customers.

That is, insurance companies will be unable to service annuities; banks will be faced with insufficient income to generate income for themselves or pay a positive deposit rate; depositors will flee; pension funds will need to revise upward pension contributions (and they are in the process of doing so) and will, in addition, roll-back promised pension benefits.

With all these private contracted benefits being challenged and ultimately being unmet, there becomes an enormous pressure on governments, not just from countries ruled by social democrats, to save the majority of voters who are adversely affected.

This then becomes an additional burden on government finance for countries already being supported by their central banks. In fact, the European Central Bank, despite an explicit treaty provision not to monetize government debt, is already doing so in earnest. Additional challenges to cover financial intermediary failures puts the ECB farther into unchartered waters for the use of the printing press.

Another source of funding would be to lean upon other governments to bail out depositors, as was done with Greece and Cyprus. However, this only strengthens pro-exit political parties in the countries financing the bailouts.

What one can expect next in these circumstances is capital flight because of the ultra-low returns-to-fixed-income investment and bank deposits becoming risky. This turns into full throttle capital flight at advanced stages, as the capital outflow continues to make the currency relatively cheaper. And wealth owners will flee that.

At that stage, financial prices reflect a flight to quality – a preference for currencies and debt instruments of countries not facing these issues – and precious metals.

The downer in economic circumstances becomes so great that countries then seek to reinvent themselves in a political-economy dimension. For European governments, compromises made in the context of the benefit of unification are re-appraised, seeking some advantage to go it alone. Going it alone allows a country its own rules and its own currency that cheapens with capital flight. The cheap currency becomes an equilibrating device as exporting becomes more promising.

That is the house of cards the EU has built, now falling one by one — and the latest unstable card in Europe are the Italian banks. They aren’t only suffering depleted investment income from low rates available on their investments but also from a backlog of defaulting loans. Italy is attempting to infuse €40 billion into its banking system with the pretense of covering losses well exceeding that. However, to do so violates the very responses that were agreed upon by the EU just two years ago.

At that time, the banking system was bolstered by an EU deposit insurance commitment that was never funded.

Instead, the EU decided to build a firewall around its banking problems to keep them from being met by the government. They mandated that their banks sell “CoCo” (contingent convertible) bonds. These bonds convert to stockholder shares when the banks admit losses. The question then becomes who takes the losses. In this case, the CoCo bond holders were set up to automatically take the hit ahead of depositors and protect the government from being called upon for a depositor bailout.

Well, things have become bad, and it’s time to convert the CoCo bonds to stock. However, the banks sold the CoCo bonds to retail clients seeking the high positive returns that such a risk should command. Now retail investors, among others, are in line to sacrifice their positions to protect the banks’ losses, which, in turn, protects the government from the need to cover those bank losses — but there is a catch. No self-respecting social democrat government will allow retail bond holders to take a hit on behalf of the banks, even if they were paid to do so.

So this is where the matters stands: the Italian government is attempting to raise €40 billion, despite a reported €360 billion of nonperforming loans, to provide a pretense of a capital infusion for the banks. This is despite the objections of the EU, as it varies from the “plan” of private capital backstops. And no other country, as you might expect, dares to step up at this time to aid Italy.

In the meantime, the market reflects a flight to quality in the prices, especially of US, German, and Swiss government bonds, the prices of silver and gold, and the sale of private personal safes. The market is just awaiting the next chapter of the soap opera called The House of Cards.

The only question is how far will disintegration go this round? And if not this round, the next?

 

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The Mad Genius of the Zero-Forever Bond

That the developed world governments are accumulating debt shouldn’t be news to anyone. To give you an idea of the proportions involved, during the Obama administration, US government debt has risen from approximately $8 trillion, accumulated over the previous 218 years of the US’s existence, to above $19 trillion and counting.

This is a 137% increase in merely seven and a half years.

Furthermore, we have now reached the point in time when Baby Boomer-related entitlements are adding to the outstanding cumulative debt. It is projected that the present value of unfunded federally obligated benefits is somewhere between $55 and $222 trillion — currently serviced by an undersized income stream of only $17 trillion.

In this state of indebtedness, the interest bill alone becomes an impediment to being able to fund entitlements (as well as everything else) unless there are some tricks up the government’s sleeves — and they are tricksters.

And here is the trick: Central banks of the developed world are pursuing ultra-low interest rates to reduce the interest burden of their governments’ debt. Indeed, Germany’s effective borrowing rate on the entirety of its debt has declined to .43 of 1 percent, and is now able to come to the market with a 10-year, zero-rate offering that will reduce it even further.

Another means to reduce the debt burden is to play games, not just with reducing interest carry but also with debt maturities. With interest expense being so cheap, there is the natural inclination by the debt managers in the US Treasury and all highly indebted countries to lock in the low rates for as long as possible.

Hence, government bond maturities are being reconsidered. The longest maturity bond of fiscally solid governments that could be sold in markets to private wealth sources had been 30 years, and few governments were able to extend debt that far out.

Or not? First, the 30-year bond maturity was stretched to 50 years in Spain and Italy, neither of which should be considered investment grade. And now France, Belgium, and Mexico have introduced “Century Bonds” — a quaint title — for debt that won’t come due for 100 years.

So the issue of how the interest cost of the debt will be handled is being settled by the mad geniuses in the world’s treasury departments. Expect to see governments placing debt maturities as far out into the future as they can. Selling debt maturities of 30 years, 50 years, or even 100 years is amateurish. The ultimate goal is to stretch the maturity into perpetuity.

And combining a zero-interest rate with a maturity of forever makes for what might be called the “Zero-Forever Bond,” which means no interest or principal will ever be owed or paid.

And here are some of the implications.

The appeal to the government issuer is that debt refinanced as a Zero-Forever Bond is the functional equivalent of a repudiation of its debt. The debt remains on the government balance sheet in perpetuity but with no consequence for the issuing government, as neither interest nor principal is ever paid. At the same time, the Zero-Forever Bond remains an asset for its owner, who never receives interest or principal.

But who would possibly purchase a Zero-Forever Bond?

To answer that question, realize that the great majority of government debt is typically placed with financial institutions that are in the business of store-housing private savings. Their combined balance sheets are well more than that of the central bank.

But without economic incentives for a private financial institution to purchase the Zero-Forever Bond, the governments would need to create some.

This is easily accomplished by financial regulation — and, in fact, it’s already underway. Just require financial institutions to appear “safe and sound,” by requiring them to purchase government debt instead of holding “risky” debt.

In addition, enticements are being given to the money market mutual funds (MMMFs) that must hold significant proportions of Treasury bonds in order to receive government insurance against shares declining to less than “a buck.”

Similarly, insurance companies are generally required to hold conservative portfolios (for which Treasuries fit the bill) and additionally Treasuries offset insufficient surplus in order to remain in regulatory capital compliance. The regulatory presumption that Treasuries are safe and sound is also used for pension fund compliance to be eligible for Federal Pension Benefit Guarantees. The Zero-Forever Bond fits the regulatory bill for all.

Basically, the Zero Forever has two sides to it: It saves the government from an actual default no matter how large its debt relative to tax proceeds because it pays nothing. But if held by private financial intermediaries as described above, they will be challenged to make good on their commitments to private savers because they won’t earn investment income on those assets held as Zero Forever Bonds (and yet, they’d be required to hold them to be in compliance).

The Zero-Forever Bond is not unlike achieving ultimate zero in other fields that causes relationships to be reversed.

In paraphrasing physicist and economist Gary Shilling, who, while commenting in his Insight publication on the central bank pursuing zero short term rates in September 2011, noted:

“….there is an analogy between interest rates near zero and temperatures near absolute zero where all activity of sub-atomic particles ceases…. Near that temperature, strange things happen [italics added]. Thermal energy arises from the motion of atoms and molecules as they collide, but at low temperatures, they don’t and atoms act identically like a single super atom. Substances that are magnetic at higher temperatures become nonmagnetic, and vice versa. Some nonconductors become super conductors — that’s why some computers are kept very cold. Others become super fluids that seem to defy gravity by crawling up the sides of their containers. Near absolute zero, a gas becomes a super liquid that can leak through solid objects….”

Well, the Zero-Forever as a perpetuity bond, which bears no interest and is crammed down on financial institutions that hold private savings, must be considered a change in nature, and in Shilling’s words would cause strange things to happen.

This effectively cancels government debt and thereby increases the net wealth of the government sector. This is done at the expense of the wealth of the financial institutions entrusted with private savings because they must hold an asset that produces absolutely nothing, compromising institutions’ obligations to private savers.

This is how governments’ prospective default is shifted to the private sector. And it’s already happening.

This is being accomplished by some Mad Geniuses in the Treasury Departments of various debt-strapped governments. It requires no public discussion, no legislation, no warnings, and no apologies. It is all quietly slipped under the rug, so to speak.

You will never hear much about it until your insurance company, pension fund, bank, or money market mutual fund is unable to deliver on its contractual obligations to you. And these institutions, not the government, will be held accountable.

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Bond Refugees Flee to Stock Lands

Tension is building among stock investors.

Stock prices have levitated, but the most fundamental determinant of stock price support — an uplift in corporate earnings — has gone soft.  The S&P 500 earnings actually declined 7.1% year-over-year and the US and moreover global economies that support it are sputtering on all cylinders.

Additionally, given the economic recovery from the Great Recession’s lows, wages are rising modestly — but with zero productivity, there is not much to offset these costs suggesting that profit margins will not hold up.

This comes on top of a seven-year run of stock prices that has outpaced the recovery of corporate earnings (as shown below), making for a relatively high price/earnings ratio as compared to historical benchmarks. All this concerns stock mavens and for good reason.

But on the other side of the ledger is the resolve of the central bank to provide a wealth effect for consumers to keep on consuming. While it’s quite clear that ultra-expansionary monetary policy carried out via bond purchases has elevated bond valuations and, in turn, produced low market yields, what support does monetary policy have for stock prices?

Picture1

Since the onset of Fed QE, there’s been a relationship between the money base and a broad stock price index (see below), but what’s the link that caused them to move together- as they have?

First, and most fundamentally, a central bank purchase of bonds from private parties is financed by new money. Hence, the other side of the bond purchase is liquidity in the hands of a portfolio manager, who then scans the financial landscape for a replacement asset that includes stocks. This is the process by which bond buying, paid for with new money, ripples out to affect prices of other assets.

From there, internal portfolio dynamics lead to increased stock purchases in the following way. When bond appreciation generates a wealth effect for investors’ portfolios (particularly institutional investors), then managers must re-balance assets and, in the process, redistribute the bond gains to other risk assets not purchased by the Fed.

Institutional rebalancing is further motivated these days when ultra-low-yield bonds create pressure to generate investment income somewhere else in the markets. This hunt for investment income can take the form of stock dividends or stock appreciation, both of which have generated total returns over the last seven years.

This is say, there is pressure to switch to assets that have become known as “alternatives,” and this has included equities, real estate, and (for a time) commodities. In essence, income investors have become bond migrants who have been forced from their preferred habitat to other asset classes.

Picture2

However, there is a simpler way to look at this process of spreading out the price increase. There is a cross-elasticity of demand among alternative assets in a portfolio — much like when a government supports meat prices, the price of fish also rises, even though the government didn’t actually buy any fish. This occurs because the expensive meat drives consumers to purchase more fish, which in turn causes fish prices to increase as well.

To an economist, this so called cross-price elasticity of demand, causes more intensive buying of substitutes when one item becomes expensive.

Another factor that leads to stock demand and levitated prices is a lower discount rate in the market. Institutional investors are not indifferent as to when income arrives: they discount future income to present day terms by discounting at the rate that could be earned on the asset if it were in-hand today — that is, what they are giving up when income arrives later in time.

In this regard, eight years of depressed yields has likely caused the discount rate applied to future earning to be reduced, which, in turn, causes the present value of future income to rise.

As an example, for a single dollar of corporate earnings that is projected to arrive in 10 years, if discounted by today’s low yields of 2%, would have a present value of 81 cents, whereas the same dollar discounted at a 5% rate would, in present value terms, be reduced to 62 cents. Hence, lower market yields boost the valuation of future income even if the future income is not projected to grow. In this case, there is a 31% increase in today’s value for 10-year out income when yields fall as far as they have.

The ultra-low interest rates further work to support stock prices as they induce companies to issue bonds with low yields and apply the proceeds to purchasing their own equity shares. While this doesn’t generate future corporate income, it does increase income per share and enhance stock prices as long as investors ignore adverse effects from a more leveraged future.

Equity share repurchases recently got a further boost when the European Central Bank took up the practice of purchasing corporate bonds at issuance, even for Euro subsidiaries of US companies.  This is likely to add to the pool of additional buy-backs of US-issued company stock. And why not when McDonald’s was able to place a 12-year maturity at a .75% rate that would make the US Treasury Department envious?

Last, in this description of stock price levitation, one should muse on the thought that maintaining stock prices at high levels has occurred despite an absence of Fed bond purchases since October 2014.

While foreign central banks keep at it (and, in the case of Japan and China, actually purchase stocks in addition to bonds), something else must be providing stock price support in the absence of additional Federal Reserve buying.

Not much thought has been given to relative scarcity as a result of bonds being purchased by central banks and stock being purchased by the issuing corporation. These assets will not see the light of day again as there is no way for them to be offered (without a change in policy) on secondary markets.

Hence, with stock and bond issues being locked up, relatively higher prices do not elicit as much of a supply response that would reduce market prices. The historical description for this is a market “cornering,” implying control over price from collecting a significant proportion of an asset — and the central banks are cornering the government bond issues. Thus scarcity allows prices to continue to be levitated thought the Fed buying has stopped.

Indeed, with this in mind, the central banks have vowed to purchase no more than 70% of any government bond issue so as to allow some private suppliers to establish a market price without being able to put much of a dent in its level.

All this is not to say that the unease felt by the stocks mavens can’t bring more supply to the market than the bond migrants will absorb if their expectations go sour.

This would push stock prices downward. But the pent-up demand by the bond migrants for stocks, together with relatively more scarce corporate shares, has changed what we think of as the fundamental yardstick for pricey risk assets.

Thus, historical stock P/E ratios as a metric for an expensive market needs revision, as we are in a whole new history of a higher ratio of money relative to asset values along with more restrictive supplies of both high quality bonds and stocks.

 

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Negative Interest Rate Neverland

For any good or commodity, if supply increases and there are too few takers, the price will fall.

If supply increases further and demand is still low, prices can fall all the way to zero.

If supply increases thereafter, and there are still too few takers, the supplier can offer a cash incentive to those willing to take the accumulated goods off their hands.

This is a negative price, so it turns out that zero is not a lower-bound price for anything.

The implication for the supplier is that the good generates negative revenues and earnings, so doing business at negative prices dissolves the supplier’s net worth. Offering products at negative prices is not a good business to be in, and if you are, you won’t be for long.

As absurd as it might seem, this has become the business model for banks in countries that are persevering under negative interest rates, primarily in Europe and Japan — and the US is not far off.

Banks and other financial institutions supply credit within the credit markets, and if there is great supply and soft demand, the interest rate (as the price of credit) can fall to zero, as in the example above.

The US and most developed countries have been at the borderline zero price of credit since the Great Recession. But it turns out that zero is not a lower bound in financial markets either.

In a sense of desperation, the European Central Bank (ECB) and the Bank of Japan are pushing the interest rate into negative territory because they are supplying credit at a negative rate to their governments and banks. That is, they are offering the borrower a zero interest rate and, in addition, paying the borrowers to borrow by requiring less repayment for the funds loaned.

So, given the need for financing ever-expanding government debt accumulation, and being scarcely able to afford its already existing interest carry, the interest meter for government borrowing goes into negative territory thanks to central bank generosity. This means governments receive more cash with each borrowing than they are required to pay back on the bonds originally purchased by the central bank.

And those terms are also being extended to private borrowers by their banks.

From the central bank’s point of view, negative rates are in vogue because they seemingly kill two birds with one stone: First, they are seen to revive a weak economy (if only the economy behaved as in Keynesian textbooks) and second, it reduces the government’s interest carry, which is great news for debt-strapped governments.

But think what that does to the lenders who are caught in the middle. Earning a negative interest rate on their assets is a net cost for lenders, so instead of receiving investment income, they are instead subsidizing borrowers.

Hence, negative interest rates are an unlegislated wealth transfer from lenders to borrowers, something, no doubt, The Bern would approve of.

In this upside down world of negative interest rates, you might ask why banks lend money with the certainty of getting less in return. This is compelled to some extent via bank asset regulation and central bank pressure to hold government bonds and deposit at the central bank at negative interest rates.

The net of it is that lenders are resisting as bank shrinkage is taking place and bank capital is being run off the books — and the equity market, understanding this, has marked down European bank stocks by 25% since the beginning of this year.

This is a financial extremum, and it doesn’t just undermine banks.

Banks are on the pathway to insolvency, and the same calculus affects all financial institutions that generally live on investment income. In addition to banks, this includes: savings banks, insurance companies, pension funds, endowment funds, and a variety of trusts (both government and private), all of which are being force-fed very low and even negative returning assets.

So you should now see the larger picture of what’s unfolding before our very eyes.

Low and negative interest rates have become the new means to subsidize broke governments and broke businesses with debt outstanding.

Now then, why have central bankers (Draghi of the European Central Bank and Kuroda of the Bank of Japan) recently renewed the pledge for yet a deeper plunge into negative interest rate Neverland?   And Yellen is studying it.

Negative Interest Rate NeverlandIs their loyalty to government subsidization above their responsibility to their own central banks’ balance sheets and the commercial banks they regulate? Or are they fools who have been seduced by Keynesian central bank ideology in which lower interest rates are seen as always better for the economy? And that includes Ben Bernanke.

There is a mindlessness going on ­— a failure to pay attention to the blatant damage to financial institutions that investors in bank stocks more clearly see. Where are the thinkers who can think beyond the dusty textbooks of the post-WWII era in which lower interest rates are applied but fail to result in the usual positive multipliers of bank credit, investment expenditures, and job creation?

Moreover, do the central banks — responsible for driving the negative market interest rates — warn the governments that all stripes of lenders will not be able to survive on such low rates on invested assets and, furthermore, expect they will come knocking on the door for major bailouts that cannot be afforded by already debt strapped governments?

This is the road we are on, and it’s a road that leads to promises made and never delivered by commercial banks, by insurance companies, by pension funds, by saving banks, and by trust funds.

When citizens come to realize that their bank deposits or pension fund payments or insurance annuities are worthless pieces of paper, will they not take to the streets in anger? From there, will not the military be called in to contain the destructive anger of its citizens and, in turn, suspend statutes and Constitutional law and place the country under a military dictatorship? It’s happened before — not in the US, but in many places in the Americas. The alternative would be to merely fire up the printing presses and satisfy those private obligations with more printed money.

So when the history book is written, who will be seen as the villain for devising negative interest rate Neverland? Will the mad genius be seen as a Treasury official of a broke government seeking an interest cost subsidy, or will it be the misguided central bankers for being enablers with their zeal for Keynesian orthodoxy?

Those are the issues and stakes involved. However, there is a positive way out, and that is for the government to change the economic environment (via regulation, taxation, or by winning the globalism competitive battle as a national goal). Sufficient economic incentives and the elimination of barriers can bring about an environment in which businesses are born and prosper and become viable borrowers and employers that can pay off loans at positive interest rates as in the good old days of yore.

These changes are within the domain of the government — not the central bank — so the upcoming elections are of extreme importance to the future of the economy, financial institutions, and the government as we know it.

Incenting and allowing businesses to be able to borrow and repay with positive rates needs to be the new operational objective of public policy. No more, “Let’s reduce the interest rate, even if already negative, as long as there are some remaining unemployed.”

Central bankers stuck in negative interest rate Neverland are naively undermining the very foundation of governments, retirement promises made, and even democracy in the process. This is darn profound stuff and well beyond being merely a Keynesian fix that has been overcooked so that it generates major adverse side effects.

The only constructive thing left for central bankers is to stand up in unison and in public and let the government know that they have done all they can and the ball is in their court. Only the legislative and executive branches can change economic incentives and remove impediments to business success so that business borrowers are once again willing and able to pay positive interest rates.

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A Grand, Simultaneous Financial Bust: Asian Contagion II

Globalism changed the economic order of things. Most relate globalism to free trade. However, the greater effects of globalism can come via the opening of capital flows among countries — both when capital surges in and when it surges out. This is now the case for a large number of developing countries. You might ask why countries would be inclined to block foreign capital inflows given that they finance investment, pump up financial prices, and generates wealth. That was understood by most, except for a few socialist countries not wanting to be tainted by capitalism despite its benefits. However, the bigger pre-globalism propensity was to restrain capital outflows. And ironically, without the ability to exit, few foreign investors were willing to enter with their capital in the first place. Globalism changed that by causing countries to relax constraints on capital outflows. Predictably, foreign investors themselves relaxed and enjoyed the greater returns available in faster growing smaller economies. So the elimination of capital outflow barriers increased the tendency of foreign investors to partake in offshore speculation, with the biggest beneficiaries being the developing countries. Foreign capital freed these countries from dependence on local savings and local banks to finance investment. And when foreign capital flowed in, it financed investment in plant and equipment for manufacturing that was leveraging low-cost labor, especially China. Foreign capital also financed office developments, infrastructure and residential condos making the skylines of places like Panama City look like this. Foreign capital provides jobs and income, but it becomes problematic because it is seldom applied at a steady and measured pace in proportion to the opportunities. During the Great Recession, the Fed’s QE provided investors with a large liquidity pool disproportionate to the onshore investment opportunities, so a good deal of that liquidity gushed into off-shore investment. And much of that went to the commodity and energy industries, which, at the time, were supply-constrained and expensive. These include Brazil, Indonesia, Russia, South Africa, and Chile, Peru among others, as well as some developed country plays in Australia, West Texas, and Canada. In investment booms fed by outside (and not very discerning) capital, animal spirit-driven developers keep on borrowing and building to be absorbed by the market before their competitors, and the unrestrained booms that follow result in over-building, excess production, inventory build-ups and in turn soft prices, debt defaults, eventual bankruptcies, and penny stocks. That much is true for any domestic boom and bust, but now there is a foreign twist when the projects are debt-financed from offshore sources that typically require repayment in US dollars. Hence, foreign-financed investment has a built-in currency crisis in the making when settlement takes place because it drives the price of the US dollar upward and the local currency downward. Predictably, it comes at a time when the boom is over-built, leaving investors scrambling to generate revenue, and commodities continue to be sold at very low prices in order to cover the rising cost of dollar-debt repayment. There is a rush to extinguish dollar debt before a property is lost to foreclosure, which, in turn, leads to major multiple market reactions – all downward. The selling of commodities at ultra-low prices creates an adverse currency movement for the affected country. For example, see the correlation (below) of the declining price of copper relative to Peru’s Sol and Iron Ore relative to the Australian Dollar. This strong currency decline then causes unrelated companies, individuals, and even governments to sell most anything denominated in local currency and use the proceeds to purchase US dollar-denominated assets. The debt repayment wave deteriorates into a generalized capital flight and a currency collapse for the involved country. Basically, the bright shining buildings shown above are still standing and shinning, but in the economic and financial dimensions, all prices are falling down. This is the basic scenario that followed the early days of globalism in which there was an over-build of manufacturing capability in the cheap labor countries of Asia in the 1990s. The consequence was a bust phase known as the Asian financial crisis that unfolded in 1997. The return of capital to the lender that spilled over to most emerging nations was therefore known as the “Asian contagion.” What occurred were falling prices of everything: over-built goods, currencies, physical capital assets, as well as the financial claims to these assets. This scenario is being repeated today in the great commodity boom of the last few years. Not only are the commodity prices falling but so, too, are the foreign currencies and foreign and domestic stocks and bonds that have financed the commodity boom. This also affects those financial entities that hold claims to commodity related securities in their portfolios. As a result, oil, coal, copper, and iron ore all are selling in the area of 70% less than when the facilities were built only two years ago. The price bust, the currency bust, the financial price bust, and the capital goods bust are in a grand, coordinated bust. The bust phase includes China’s over-expanded manufacturing sector that gave rise to the commodity boom in the first place. Meanwhile, the question becomes: Can the US economy continue to grow in the face of this? There are adverse implications for US companies are attempting to export goods (in the face of a relatively expensive dollar) to a developing world in recession. The foreign sales and earnings of these companies are being hurt, and that hurt is being registered in the US equity market. But meanwhile, American companies and consumers are benefitting from the cheaper import and energy cost savings. Indeed, the service sector is holding up the US economy. When the dust settles, US companies will leverage the cheap prices of foreign-made goods and increase their profit margins. Indeed, Dell Computer back in the late 1990s became a break out company that benefitted enormously from the first Asian Contagion because it was outsourcing production to the countries whose currency was most affected. Distressed prices of foreign currencies and assets will become a high return opportunity for the US dollar investor willing to patiently wait it out. Subsequently, one must keep an eye on commodity inventories. When inventories start to work their way down, there is a bottoming-out of commodity prices, which, in this slow growth environment, could take some time. This will likely be measured in years, but no doubt its day will come. The reversal of cheap currency in the EMs will set a bottom and bring capital back to those countries with a rush. At that time, all the prices that have fallen together will all rise in unison. So it seems that two decades into globalism, we are finding that global capital flows — first gushing in and then gushing out of relatively smaller countries — add a new dimension of volatility to financial markets with a foreign currency twist. These are relatively long cycles, so investors must be patient. In the meantime, producers in developed countries will benefit from rising profit margins thanks to cheap foreign outsources.

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Tell Spellman It’s an Art, Not a Science

Economies mutate. This occurs when responses among variables in the economy start to change. In the terminology of economics, the elasticities have changed and they, in turn, change the behavior of the entire economic system.

These can be due to changes in incentives (or the reactions to incentives), changes in the rules (either regulatory or legal), or changes in supply conditions. And then there is technology, which constantly morphs.

So relationships that one has become accustomed to may not hold up as they did for decades. Ultimately, they were not written in stone.

For the designated managers of the US economy, The Federal Reserve Open Market Committee who influence financial variables as a means to bring about desired changes to a national economy such as for employment and inflation, this is a perplexing task.   To manage it, economists have endeavored to model the economic system mathematically based on a history of economic reactions. They then seek to derive simple rules for adjusting the variables subject to their control to bring about the desired end results.

Therein lies the development of “rules of thumb” for how to manage the economy. One such example is the Taylor Rule for interest rates to smooth economic cycles. Another was Milton Friedman’s dictate to keep the money supply growing at a constant rate. And there are a lot more.

However, once these simple rules of thumb are developed, often mutations creep in and the rules no longer work as well (or at all), and policy becomes a perplexing endeavor — and that’s where we are today.

It’s in this context that we should view the work of the besieged members of the Federal Open Market Committee who make the call as to whether or not to attempt to raise interest rates. It’s clear they have been perplexed for some time as to whether or not to pull the trigger.

Rather than scorn these poor public servants, it would be more appropriate to pity these mere mortals who are tasked to keep the economy and financial markets running smoothly as per their instructions via the Full Employment Act of 1946.

The question of raising interest rates at the moment has become a much ballyhooed event for which every investor, financial writer, and taxi cab driver no doubt has his or her own opinion mostly held with near certainty.

After all, it’s a momentous event when, after seven years of buying securities and adding quantum leaps to its balance sheet, the Fed contemplates switching to selling securities in order to lower financial prices and raise interest rates as a means to glide to a new economic growth path.

To undertake the task of economic management that was thrust upon the government about 70 years ago, economists both inside and outside the Federal Reserve attempt to systematically estimate as exactly as possible the restraining and simulative effects of Fed actions.

That is, the financial variables that are life and death to investors are, to the Fed, a means to an end: economic stabilization. More broadly, the mandate is to adjust the financial variables in order to iron out the excesses of the spending cycles — both the highs and the lows relative to the available resources. The objective is to produce smooth spending growth that matches the level of and the growth of the supply capability.

The supply side target is called Potential GDP and it’s not static. That is, the supply side target moves through time when labor and capital resources grow and productivity advances and the matchup would result in no more than 5% unemployment and an inflation rate of about 2%. Undershoot it and the unemployment rate is higher and over shooting would result in higher inflation.

So this process of matching up spending with the growing supply capability is akin to trying to send a rocket to the moon and produce a soft landing. The policymakers are trying to produce a spending trajectory that neither misses the moving target to either the high or low side, least we have unacceptable unemployment or inflation.

Obviously, this requires a good deal of estimation of not just the path of the target but how the system will move and react to policy controls to reach the target.

To do so, the science (or, some would say, the art) of econometrics was developed to mathematically model the systems reactions to the financial variables that the Fed can control based on past data.

From the point of view of the econometric creators of the mathematical version of the economic-financial system…this was the linkage from the Fed’s controlled variable to the variables that Congressman tasked them to hit …some version of full employment and price level stability.

So for many years since at least the l960s, econometric models of the system of responses have been built and added to each year. Of course, it’s based on the precious little data. Because there are many variables to be estimated, accuracy requires that economists collect a lot of data.

More important, reducing estimation errors also requires collecting more relevant data. For example, in picking the voters’ choice for the Republican nomination, one would not to care to rely on a sample of fifteen voters which is not much greater than the number of candidates. More accurate estimates of many variables derive from a sample of many thousands.

So as to be able to obtain as much data as possible to make estimates of how the variables of the economy react to each other, the economists had to go back to the data bin of past experiences and recreate the data starting in 1929.

But herein lies the rub of the scientific approach: to enlarge the sample size, which is still at bare minimum levels relative to the number of variables that are involved, they looked backwards and relied on history — but history can be fickle. Mutations to the underlying elasticities create a misleading database.

So they have been in a quandary as to whether or not to raise interest rates because the system they had thought they understood suddenly stopped working in its usual way.

Stimulus was applied in some great multiple of any previous stimulus, but the reaction has been weak and late to materialize.

The source of the uncertainty is the new context of the economy as it labors to produce positive results within an open global system of not just foreign goods competing with domestic goods but also with the wild card of foreign capital flows that are capable of gushing in or out of a country and offsetting or magnifying Federal Reserve changes in available market funding.

Moreover, exchange rates have become flexible and no longer fixed by governments, and there is no insulation from foreign capital inflows or outflows. So when the US dollar strengthens, as it has, the products of US multi-nationals get priced out of foreign markets. Further, the changing exchange rates drive capital in and out of countries, which accounts for far more financial buying power than the Federal Reserve would dare employ.

To make matters more difficult, foreign central banks are motivated to protect their own end of the global bargain and offset Fed actions that are self-serving to the US. Furthermore, the US banking system has not responded to the availability of cash reserves remotely near past responses.

So one should understand the complications are not just determining the path of the “moon” that our rocket is chasing but also the responsiveness of the rocket to the Fed’s control tower.

So the question is, is policymaking today an art or a science given that the models they have to go on fail to capture the essence of today’s elasticities?

This idea causes me to harken back to an experience I had in the l960s when I was an economist at the Federal Reserve. At the time, economists (myself included) were agog over the science of being able to model the responses to policy.

To do so, I constructed a model of the economy on an analog computer, which was ideal for tracking the interactions of the financial and economic variables over time. There was a lot of experimentation to set the elasticities so that the resulting system reactions followed patterns that were similar to the then-current economy.

To give the experiment some life, I set about simulating what the Fed’s Chairman at the time described to be his method of stabilizing the economy. He called it “leaning against the wind.” While highly suggestive, it needed to be fleshed out. I came up with a few versions of practical implementations of what could arguably be a policy rule for “leaning against the wind.”

I presented the methodology and results to a staff economist colloquium that also included most of the Governors who sit on the Federal Open Market Committee.

The response was dramatic among those tasked with deriving a mathematical response to policy stimulus. Alas, the paper and news of the presentation reached the Chairman whose considered response was that someone should “tell Spellman that monetary policy is an art, not a science.”

Over the following decades, the scientific approach to modeling has attempted to be more precise, but during those same decades, the underlying system mutated and there is insufficient historical data that’s relevant to today’s mutated economy.

So now we have come full circle. The Fed, in making its historic interest rate decision, is left only with art and models built from less relevant data, which for them is an uncomfortable place to be as the policymakers these days are trained scientists, not artists.

Let’s hope they have the courage to move on even though they lack the scientific proof that, indeed, raising interest rates would push the economy toward absorbing the last of the unemployed while not trigging incipient inflation, nor which would send the economy back into the Great Recession.

At this point in life, decades later, I’ve come to agree with the Chairman of bygone days. Policymaking is an art, not a science. This is not to say they shouldn’t lean on what science would suggest.

This is not a comfortable place to be when having the responsibility for the outcomes ahead, so I do watch for nervous twitches as they testify before Congress and global financial opinion.

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