Economy and financial market pricing Archives - Page 2 of 3

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.

The US Growth Machine is Red Taped to Death

With the onset of the Great Recession, the revival tools of monetary and fiscal policy were applied in the extreme to resuscitate spending and return solvency to the banking system. All textbook Keynesian approaches to restoring demand levels to previously attained aggregate supply.

That much has been accomplished. But now seven years later, the realisation has sunk in that a return to the economy’s past high water mark is not the same as causing the high water mark to continue to grow at rates the US economy had been accustomed to. Keynesianism did its job of restoring aggregate demand to already existing aggregate supply levels.

But resuming economic growth from there requires growing a globally competitive supply capability as well.

Certainly the Fed’s obsession with holding interest to near zero is not doing the job because as cheap as the Fed can make credit there are too few takers to translate that cheap credit into business investment that leads to spending, productivity, competitiveness, jobs, wage growth and wealth.

While the price of credit factors into that chain of events, that, in itself, is not sufficient to do the job because credit cost is but one side of the market and business borrowers’ and their capex motivations is the other.

We can chastise the Federal Reserve either for being unable to get itself to move off of a zero cost of credit, as it does have harmful side effects, or we can chastise the Fed for a lack of growth but the Fed has no other way to influence the growth machine.

Only Congress and a President do and the Fed would be doing a public service if they stated so publicly, instead of putting the onus on the back of a central bank that can’t influence the desire for business investment capable of producing growth.

Essentially, it all goes back to William McChesney Martin’s observation that monetary policy is “pushing on a string.” That is, the central bank is better in reining in business adventurism than motivating it.

Just why nearly free credit is not causing businesses to jump on investment opportunities certainly has to do with confidence and taxation but mostly its red tape that inhibits the instinct to take the cheap money and invest in new, real things.

Regulatory red tape whether calculated by the costs to fathom how to build and shape your businesses adventure and be aware of its legal exposure, sometimes criminal, seems to be inhibiting the instinct to take the near zero money.

And without a healthy investment response to credit availability there are poor economic outcomes. Indeed, the decline in Real Median Family Income did not gone unnoticed in the first Democratic Party debate which showed interest in the issue of red tape so much as it ultimately relates to income distribution, but nary a mention at the Republican debates.

But to do something about red tape that binds businesses would require some focus and measurement without which it is not easy to highlight its adverse influence on growth. What we are talking about is measuring the opportunity cost (the loss of) new goods, and output and jobs due to red tape constraining business from undertaking projects and new businesses to enter markets. There is obviously a major problem with a declining census of the number of businesses in America.

But how does one measure what was lost when we never had it to begin with, in order to understand the significance of the red tape constraint to economic opportunity and growth.

Instead we are left with arguments of logic or measurements of tell-tale signs of red tape to attempt to make a convincing argument of it smothering effects such as how many pages are there of Federal Regulation (174,000 as of 2010) or how many feet tall is the pile of the Code of Federal Regulations volumes, if piled one on top of another (24 feet) or the total number of restrictions that contain language of “shall” or “will” (over a million by 2012) or what is the multiplier of regulations that emanate from the average piece of Federal legislation (27).

Or what percent of Federal government revenues are spent on regulatory bodies that ostensibly read and act on the regulatory reports or what is the dollar cost of corporate and personal compliance to regulation? Does that make the argument?

All those numbers are large but still do not accurately convey what is lost in terms of output and goods and firms and the employees of firms that either didn’t survive or were still-born because of the constraints and the cost of fathoming and adopting to the rat maze of regulation.

While we can’t totally give up hope for a return to free enterprise as it has happened before. During the Jimmy Carter Administration every regulation was looked upon with disdain and many, many regulations and even regulatory bodies were dispatched.

But alas hope is on the horizon.

The Mercatus Institute at George Mason University’s efforts at documentation of the regulatory load is bringing some measure of the cost of regulation to attention. Furthermore there is the Simon Frasier University country indices of economic freedom.

And now the World Bank is involved in lending credibility to the issue and ranking the US in the global spectrum of regulation. It’s all published in its annual “Doing Business” where the World Bank counts the opportunity cost in days lost to start a business such as for obtaining a construction permit, the registration of a property, paying taxes, obtaining an export or import license or enforcing a contract as measures of time lost.

In this regard the World Bank finds that in most countries, days lost to regulatory matters are generally declining but for a group of 20 countries, the cost of regulatory days lost is rising. As you could guess that group includes the US which is ranked sixth among those countries with an 18% increase in regulatory days lost since 2000.

Now we are starting to get somewhere in terms of defining the size of the regulatory overhead but that measure still doesn’t carry the authenticity that interest rate multipliers do. So the Fed’s ultra-low interest rates still gets all the attention as if it would take care of the economic growth problem while de-regulation remains a step child in the policy domain.

Probably the best way to appreciate the problem is to contemplate being an entrepreneur in today’s regulatory environment and think of the number of regulations required to be navigated and the number of times per day you are exposing yourself, not just to fines but criminal indictments and the billable legal hours that go with it. Apparently, it is taking its toll as the number of corporate “deaths” exceed the number of corporate “births” each year.

Whatever the “multiplier” effect from de-regulation, it has to be greater than the stimulus effect of continuing to keep interest rates about 200 basis points below all-time lows and keeping it there for almost seven years.

It’s time for the Federal Reserve to go public with a direct enough SOS for Congress and a President to hear and understand because they can’t do the job of promoting economic growth with credit cost and availability alone. Accomplishing growth also needs unshackled, ready willing and able users of the credit to produce economic vitality with the credit being offered.

The Next Leg of Globalism

In 1993, there was a great debate carried live on national TV between then-Vice President Al Gore and Dallas entrepreneur Ross Perot. The issue was the pros and cons of going global — that is, whether the U.S. should allow foreign-made goods to be sold in the U.S. without tariffs or other barriers if, in turn, barriers were eliminated for U.S.-made goods. And if you can believe it, the decision that required landmark legislation was rendered thanks to a public opinion poll that provided guidance to the politicians.

Even more unusual by today’s political environment, the case for opening trade was presented by the Democrat, Al Gore. His argument was that the elimination of trade barriers would, on balance, be to the U.S.’s advantage because it would unshackle its producers so they could export and outcompete foreign producers (tires made in Tennessee and shipped to Mexico was his example).

Equally unusual in terms of today’s political alignment was the right-leaning Perot (as the Donald Trump of his time) arguing against globalism. His position was that the lower wages abroad would result in a “giant sucking sound” of jobs lost to lower-wage countries.

Well two decades later, there is no doubt who got it right.

Yes, globalism did open foreign markets to U.S.-made goods and created jobs, but on balance, the “giant sucking sound” was the demand being sucked out of U.S. labor markets.

If the Democrats look at this as a victory, it’s because it created a lot of future Democratic voters who wanted to respond to the sapping of jobs, wages, and income. Simply put, globalism has undercut the real median household income, which is today lower than it was in 1990s, and created the Bernie Sanders Democrats we hear from today.

So it’s been a rough adjustment, not just for the U.S. but also for the other countries that called themselves “developed.” This included Europe and Japan and a few others that had relatively higher wages at the time.

Now in 2015, two decades removed from the debate and probably three decades from the general loosening of trade barriers in one form or another, we find ourselves in a world in which the old dichotomy of developed countries vs. less-developed countries is no longer applicable. Those less- developed morphed into being emerging for a time and have now emerged, and they have undercut developed nations in the process.

This a watershed moment in time when a post-Communist country like China has virtually run the table on developed world manufacturing to shift to their economy.

It has been a process of meeting in the middle with most countries now, more or less, equally developed. China has risen from nowhere to be second to the U.S. in GDP and in number of millionaires. This is the logical conclusion of the opening of trade in a two-wage-rate world.

But in the race to economic development, China’s economy was driven by a roughly 50 percent share of GDP spending in the form of plant and equipment, which has now created an oversupply of manufacturing capacity.

And the same applies to commodity producers, whether from emerging markets, Canada, or Australia. During the last decades, their capacity to meet manufacturing and infrastructure demands grew dramatically, but now they find themselves in a state of oversupply while demand moderates.

Thus, we are in a Kondratieff world in which the long cycle of building generated excess supply — in this case, manufacturing and commodity capability. What follows are falling prices and slack future demand, causing plants to close and new ghost towns to pop up. And I’m not describing Muncie, Indiana, or the U.S. rustbelt but rather Chengdu, China when it recently closed its steel plant.

Globalism has reached its logical conclusion: Over-supply and cheaper goods, but at least it’s an end to the leakage of U.S. manufacturing abroad. It’s been a 30-year uphill battle for the developed world.

At this stage, it takes down the financing of the manufacturing and commodity expansion and all those who financed it. It takes down demand for new plant and equipment substantially, and it takes down the governments’ tax revenues and country credit ratings for those who formerly succeeded.

And there is a strong currency component to this as well: U.S. dollars borrowed during the expansion are being repaid while dollar revenues earned from the export of manufactured goods and commodities are slack.

All in all, this is the dynamic that played out in 1997, known then as the Asian contagion. However in this go-round, the U.S. is not in a tech boom as it was then, so keeping up growth in the developed world will be more difficult.

This leaves the old-time developed world still floundering with continued over-reliance on QEs that don’t do much to stimulate the economy, nor do they produce inflation (no matter how hard their central banks try). But all in all, from here on out at least, the China leakage is over, and there will be benefits from expending a lower proportion of income for the same imported products.

Country Debt Enablers and the Greek Conundrum

For a country such as Greece with little penchant to tax and a greater penchant to spend, financing its fiscal deficit is an ongoing chore. But when it comes to financing those deficits, governments have tricks up their collective sleeves — ones not available to the private sector.

What makes it relatively easy is that most government debt “sales” are not a sale at all. There is no counter-party buyer that is able to judge the value of the debt being accepted into its portfolio and price it accordingly. Rather, government debt placement tends to be crammed down onto some balance sheet, either private or public, rather than “sold” on a market.

Put another way, governments seek to eliminate the market test and, as a result, their debt is placed at yields that doesn’t reflect the risk that a market would ordinarily require. This accounts in part for the trivial “market” yields on deeply indebted government debt across the world. For example, for ten year durations, Spain and Italy’s government debt yields are well those of the U. S. which themselves are suppressed.

This ability to cram debt down cheaply enables the accumulation of government debt to the point that the only deterrent to doing more so has become the willingness to tax sufficiently to be able to pay the suppressed interest cost. And when that market test can’t be met, all hell breaks loose — as it has in Greece.

Here is how the government debt enablers work:

The first trick is for governments to encourage its citizens to regularly purchase government debt via a “payroll savings plan.” That is, convert private savings immediately into non-marketable government debt much like the U.S. did with large-scale Savings or War Bond programs during WWII.

These programs are initially voluntary but morph into mandates. For example, during WWII, the U.S. government required 100 percent compliance among employees of defense-related businesses — to participate, or risk losing your government contract.

During Vietnam, a more egregious cram-down occurred when the arms most easily twisted into participating in “voluntarily” government debt purchases were those of the soldiers themselves. Those conscripted to military service bore the dubious distinction of both fighting and financing the war via mandatory saving bonds in lieu of pay.

But “voluntary” government efforts to lock into private savings are not just for wartime. Recently, for example, the Middle Class Task Force of the Obama White House proposed to “strengthen middle class finances” via voluntary savings funneled into a “Safe Investment Choices” program (p. 25). Of course, with the government acting as your investment manager, to them there would be no conflict of interest in funneling your private savings into wonderful “riskless” U.S. Treasuries, which is what was proposed.

Much the same regularly occurs for government “trust” funds, whether they are part of social insurance or for other future services such as Medicare, Medicare, or the highway trust fund.

From there, public capital markets are tapped though the sale of government bonds but with either a whiff of coercion or special enticement, so the market test is deeply biased.

For example, a factor in the marketability of government bonds at yields attractive to the issuer depends on the currency in which the bond’s payments are denominated.

From an investor perspective, Greece’s bonds — payable in Euros — are considerably more desirable than if they were denominated in Greek Drachma. This is because the Euro’s value is supported by the demand for Euro currency to purchase the goods of more successful European exporters. However, the ability to piggyback off the relative strength of the Euro currency to sell Greek bonds doesn’t require Greece to remain in the Euro currency. Countries, for example, regularly finance their debt denominated in the U.S. dollar without being part of the U.S.

So the importance of remaining in the Eurozone for Greece is to court the purchases of their debt by the European Central Bank (ECB) and other Euro government’s intent on defending the benefits of European economic integration as a means to provide disincentives for European conflicts, as occurred in the past.

Another consideration regarding a government’s ability to finance its debt and contain its cost is the credit rating of its sovereign debt. Hence, governments regularly pressure private credit rating agencies to issue pristine ratings whether or not their debt is pristine. Here, too, Greece benefits from being in the Eurozone.

Getting the Euro sovereign ratings under control is important because the ECB purchases of country debt require investment-grade ratings. When it appeared that private rating agencies would not deliver the necessary investment-grade ratings, the ECB contemplated creating its own rating system to produce whatever rating it wanted.

Apparently a way has been found to elevate Euro sovereign debt ratings because, as the ECB notes, Euro sovereign debt ratings have seen a “persistent upward trend for counties with weaker fiscal fundamentals.” Clearly, ratings are being manipulated to Greece’s and other countries’ benefit to allow ECB purchases.

But there are more tricks in the tool chest to sell government debt. When sovereign debt can’t stand on its own two feet and be sold in amounts and affordable yields to finance a fiscal short fall, then governments must get more creative. And they do.

Under the guise (or, rather, the subterfuge) of insuring the “safety and soundness” of financial institutions, government-styled financial regulation requires those institutions to purchase and hold government debt as a “riskless” asset — which, ostensibly, protects the investing public.

The way this is done is to define general categories of assets that financial institutions must own — a requirement that is virtually only met by government bonds.

For example, “risk-based” capital requirements motivate financial institutions to include a larger proportion of “riskless” government debt in their portfolios, which allows banks to operate with less capital. This mutually convenient arrangement (facilitating government debt issuance to banks that are thus able to reduce its capital requirement) at this stage of the Greek game is haunting bank depositors.

They see the banks holding overly generous amounts of wobbly Greek government debt and (correctly) fear the banks don’t have the assets left to make good on their deposits. This is what led to Greece’s bank deposit runs, causing depositors to get in line and withdraw their money as quickly as possible. In these circumstances, the government deposit insurance guarantees that would supposedly cover their losses are vacuous, which further intensifies the panic.

The need to provide the cash to feed the bank deposit run from Greek banks has been funded via emergency “liquidity” loans from the ECB, though the banks have now run out of eligible assets to pledge as collateral against these cash loans as required by ECB rules. As a result, the banks have been in the process of pilfering cash held in individuals’ private safe deposit boxes and replacing it with a bank IOU.

The next step of obtaining other people’s money to keep the government afloat is for governments to borrow from each other. For the U.S., this is relatively easy because the U.S. dollar is still a reserve currency, and those foreign governments that wish to hold foreign exchange reserves translate their dollars into interest-bearing U.S. Treasuries. But Greece is not equally fortunate. Its bonds don’t qualify as a foreign reserve.

So in the category of borrowing from sovereigns, Greece has had to lean further on the IMF, the EU, and the ECB to (once again) forgive past debt and (again) refinance the rest on cheaper terms and longer durations and to seek additional cash. But it’s clear with Greece’s economy laboring to carry its existing debt that additional debt would no more be serviced than its past debt obligations. Greece is beyond the “bang point” — the point at which the debt prevents the economy from attaining a growth rate sufficient to generate needed tax revenues to service the interest on existing debt.

Having run out of resources and lenders, the issue is this: Is it in the interest of the Eurozone to keep Greece afloat? On this matter, Greece has resorted to upping the ante by threatening to ally itself with the Russians, playing off its strategic geopolitical position at the southeast corner of the Eurozone. It’s Europe’s first line of defense. This is perhaps what has caused some sentiment within the Eurozone to continue supporting Greece, but the amount of tribute is not trivial. The forgiveness of a portion of the 186 billion Euro debt and an additional 86 billion Euro loan have been discussed.

The alternative for Europe, which is growing in favor, is the therapeutic value of finally saying no to additional Greek financings. This would mean absorbing the default on 186 billion Euro of loans made to Greece and to cut Greece off from further Eurozone or ECB borrowing. Cutting off access to the Euro currency and ECB loans would force Greece to return to its own currency. This has been cleverly dubbed “Grexit,” and would result in Greece providing banks with Drachma to satisfy bank deposit withdrawals.

By cutting off additional financial assistance to Greece, the goal here would be for Greece to serve as a model of what happens to governments whose penchant to spend exceeds its penchant to collect taxes, for which Greece is not alone.

Ironically, this tough love is in Greece’s best interest because with its own currency, Greece can make its olives, shipping, tourism and anything else as cheap as it wishes for the global markets. By also defaulting, this would greatly diminish the taxes needed to pay interest and principle on the mountain of past debt.

The Catch 22 is that Greece would need to run a balanced fiscal budget even if it were to be debt free (via default). That is, government spending in the future would be limited to tax proceeds because the market would not touch Greek debt denominated in either Euro or Drachma for years to come.

So the Greek endgame is as follows: unemployment of 25 percent, negative economic growth four years running amounting to a depression, a private banking and wealth meltdown, significant emigration of its youth, who face a 50 percent unemployment rate, and a likely need to go back to a post-WWII square-one to reestablish its economy based on its own currency while living on its own resources. This has become Greece’s fate for debt overindulgence.

But if Europe offers more debt assistance, Greece’s debt load only mounts. As a consequence, Greece will be worse off because it is well beyond the “bang point” — the ratio of the country’s debt to income is rising to nearly 200 percent given the very recent collapse in GDP. And as a consequence, European lenders have almost no chance of collection.

Upon reflection, Greece’s switching to the Euro currency in 2002 only facilitated its ability to borrow more than it could handle and ultimately begot greater pain and suffering. Not much different from private parties that leverage off of connections and overdose on debt and end up with lower income and a cram-down of assets when bankruptcy is reached.

Will Greece’s debt demonstration project influence populations not to elect populist leaders who are ultimately unable to deliver as promised and accept the adverse consequences from trying?

Or will they go further left and be unable to finance themselves any longer — even when using their tricks of the trade — and seize the last remaining sources of private wealth and party until they, too, are spent? We shall soon see.

The Cats and Dogs of the Equity Markets

Some 70 years ago, Congress spelled out the economic growth objectives for the U.S. economy in the Full Employment Act of 1946. The mandate was for the government to support policies that would bring about sufficient economic growth so that employment would become “full.” Congress also included a restraint to the mandate that would limit inflation, but over time, both interpretations and priorities change. After all, this is politics as well as policy.

In aiming for full employment while controlling for inflation, the greatest responsibility fell on the shoulders of the Federal Reserve, which had the short-term flexibility to vary the cost of credit to manipulate aggregate demand.

To do so, there had to be an understanding of how much aggregate spending was needed to generate employment levels considered to be “full” without accelerating the inflation rate. This led to the development of a macroeconomic target called “Potential GDP,” which defined how much GDP spending would be needed to create enough demand in markets that would cause firms to hire just the number of workers consistent with full employment. Too few, and targets wouldn’t be met. Too many, and there would be inflation.

The goal, then, was for the Fed to match an equal amount of demand to Potential. This concept and its calculation was the work of Arthur Okun in l962 that become known as Okun’s Law.

The second link of what needed to be established is how that amount of aggregate demand would relate to the Federal Reserve’s main policy instrument, the short-term interest rate. This was accomplished by the Taylor Rule in the early l990s. It provided an estimate of the short-term interest rate that would generate the demand that would cause business firms to hire enough workers so as to be at full employment.

All these machinations of determining the right short-term interest rate to drive spending to the right number that would, in turn, cause businesses to hire the right number of workers to claim that employment is full is an ongoing exercise because the relationships that determine that interest rate are constantly changing. That is to say, the latest calculation of Okun’s Law (how much spending is needed) and the Taylor Rule (what interest rate creates that amount of spending) are subject to the latest economy-wide responses — and those do change.

For Wall Street, the Federal Reserve’s plan to raise interest rates, is seen as an attempt to put a dent in the economy and, hence, corporate profit growth and — in turn — stock prices. What Wall Street doesn’t realize is that the interest rate adjustment is supposedly one that will get the economy to full employment (and prevent inflation acceleration) and keep it there.

But the stock market’s obsession with the Fed’s intention to raise interest rates is largely misplaced: The Fed is looking to maintain growth, while allowing for some inflation which is viewed as a means to depreciate debt outstanding. To the extent there will be an interest rate increase, it’s likely to be little and late and an almost symbolic fulfillment of their duel Congressional mandate.

Nonetheless, all the major stock market indexes for U.S. equities since the beginning of the year are flat, reflecting a deterrent to growth that the Fed rate adjustment would supposedly create.

But there is other reason for Wall Street to be concerned with the general advance of stock prices.

When employment growth occurs, as it has, in this slow-motion up-cycle, labor becomes relatively scarce and wages increase. That’s the whole point of the macroeconomic exercise of targeting full employment. But in turn, rising wage rates increase the costs of production, which reduces profit margins and total profit.

We are at that point for many firms. Actually, we are beyond that point.

The more ominous rate for Wall Street should be the wage rate — not the interest rate — that flows into corporate employee costs. This creates a larger dent to overall profit than is being added either by more output and/or higher prices as the economy approaches Potential.

The wage component of employee costs is now bumping along at close to a 3 percent rate, but that only partially reveals the deterioration of profit due to employee compensation. There is a rarely viewed government statistic called the ECEC, or the Employer Cost of Employee Compensation. This calculates the employment cost to employers, taking into account not only wages but also benefits. Those have amounted to a 4.9 percent increase over the past two quarters.

The employee cost component is rising, but employee benefits are rising at a more substantial pace as the Affordable Care Act (among others) kicks in.

But that still doesn’t fully reveal the dent in corporate profit that will be delivered from tighter labor market conditions. It’s not just employee expenses that matter but also the extent to which those costs are offset by greater productivity of labor. That is, if labor costs rise and are offset by more output per employee, labor cost per unit of output can actually decline, resulting in a larger bottom line. But that’s not happening. Rather, the opposite is occurring.

The Bureau of Labor Statistics indicates: “Productivity decreased 3.1 percent in the nonfarm business sector in the first quarter of 2015; unit labor costs increased 6.7 percent (seasonally adjusted annual rates).” In manufacturing, productivity decreased 1.0 percent and unit labor costs increased 3.4 percent.

The significance of this 6.7 percent increase in unit labor cost must be compared to profit margins per unit. On average, pre-tax profit (as a percentage of corporate value added, as a proxy for profit margins) is at a very high 12 percent per unit produced, as can be seen below. Hence, we are looking at a collection of firms potentially losing half of pre-tax operating profit to employee compensation — and stock market shocks will follow.

Thus there is a built-in contradiction of achieving macroeconomic success of driving the economy to where employment is full and simultaneously providing stock market returns. The only way the two can simultaneously occur is if firms invest in capital equipment to raise productivity more than the growth in employment costs. But that happy state of affairs is not occurring.

So at this juncture of the business cycle expansion, we are looking at increasing labor cost per unit produced with a large dent to profit margins and reduced profits for firms with heavy dependence on U.S. labor. This implies U.S. service industries are the most vulnerable.

But yet there is still a stock market opportunity with widening profit margins for firms that use foreign labor (via outsourcing) and are paid in cheaper foreign currency given the stronger U.S. dollar.

Some firms will benefit from global access to cheaper employee costs. Basically, there will be a dispersion of positive and negative shocks from firm to firm with the ratio of the advancing-to-declining stock decreasing. Some stocks will become dogs and other will be purring cats of profit expansion due to cheap foreign labor.

The implication for investing in a broadly diversified range of firms would mix the dogs with the cats and the outcome would reflect the same: stagnant returns on average, along with a general sense of uncertainty as some firms experience earnings surprises, both positive and negative.

Firms that benefit from this macroeconomic environment are those that deliver goods to U.S. consumers that are produced more cheaply abroad. Detecting and targeting those cats from the dogs in this environment is more the issue for U.S. stock market investors than a generalized fear of interest rate liftoff.

Manna from Heaven and Government Debt

Baby Boomer entitlements, long viewed as an over-the-horizon problem, are now upon us. These unfunded liabilities are morphing from a forecast into actual debt, a process that will continue for decades, and the accumulated debt is already undermining aggregate economic performance. It’s a problem that is crying out to be addressed and the sooner the better.

The implications of government debt accumulation have been the subject of posts on this site and throughout the blogosphere, but the topic usually receives a “head in the sand” treatment from governments and politicians, alike because the implied cure — to rescind entitlements — is a political third-rail.

If not addressed, debt default ultimately occurs, but that doesn’t seem to even arouse a response other than the hope that it occurs on someone else’s watch. (Observe the Greek debt theatre being played out.)

So the question is: What fixes can governments apply now that can still sustain the economy and all the things that go with it? Certainly supply-side policy should be front and centre in that discussion. Everything the government does needs to be viewed from the prism of economic growth which provides the income to sustain debt.

Having run out of conventional solutions within a government toolbox of macroeconomic fixes, the European Central Bank (ECB) is implementing a desperate or some might say a creative and subtle use of its money printing ability. Sadly for Europe though, it will have unfortunate side effects.

The policy, while being labelled quantitative easing (QE), is much more than a monetary policy to create extreme low interest rates. It also has a Manna from Heaven component that can be used for multiple purposes. Allow me to explain.

Quantitative easing originated in Japan and also turned up in the U.S. as large-scale central bank bond purchases. While it seems on the surface to be Keynesian interest rate policy, its more pressing, unspoken reason was debt service containment, both for government and private debt.

Manna from Heaven is unleashed when QE, as implemented by the ECB, is taken to the next extreme level. The ECB intends to buy a large quantity of Euro investment-grade debt, including sovereign debt on secondary markets. To reach their target requires that the ECB offer a higher price to induce present owners of investment-grade debt to sell their holdings to the central bank.

Investment-grade bond purchases by the ECB have been targeted to be approximately twice the current issuance of investment-grade debt (for both private and government issuers) hence reducing the available supply of investment-grade bonds in the market. That puts financial institutions and foreign central banks in a bind given their mandates to hold bonds of this character.

Therefore, there is great competition for Euro-denominated investment-grade debt, and it becomes scarcer with each ECB purchase, driving investment-grade bond prices not just higher but in excess of the principal and all interest until maturity for most debt issues. This is the definition of negative interest rates and reveals how it comes about for market-traded debt. The premium prices paid for by new money issuance is the Manna from Heaven and generates windfall gains for the sellers.

And in the hope of not being considered too irresponsible, the ECB has put a cap on the price premium above the bonds’ total proceeds of 20 percent (which puts a floor under just how “negative” interest rates can go).

Despite the premium prices the ECB is willing to pay for investment-grade bonds, it has come to believe that there will not be sufficient availability of offered bonds on secondary markets to meet their quantity objectives. As a cover narrative, they claim their quantity goals can only be reached if they also purchase original issuance of Euro sovereign bonds at up to the 20 percent premium despite the Euro prohibition on such transactions.

Now think about what that means, as it means a lot.

First, the premium prices paid produce negative yields not only for the central bank buyer but also for pension funds, insurance companies, banks, and endowment obligations (or savers in general who invest in this market). While the central banks can “afford” negative yields, most certainly the private institutions cannot — and they are ultimately on a collision path of not being able to fulfil their contractual obligations when their investment income derived from bonds declines so dramatically. They then become future government bailouts waiting to happen that would substantially add to government debt.

Second, the ability of the central bank to pay premium prices for investment-grade bonds results in windfalls for both debt holders and debt issuers. For them it’s veritable Manna from Heaven financed via central bank printing.

Third, with the price paid being greater than all future commitments on the part of the debt issuers’ means there now becomes a large incentive to keep issuing debt, including government issuers, as they receive greater proceeds than their corresponding obligations. Or to put it another way, they are being paid to borrow.

Fourth, the Manna becomes a new free policy option for governments. Their choice becomes to use the excess cash proceeds to either retire other government debt obligations and dissolve their debt overhang or will they choose to issue yet more debt for which they are being paid? Or yet will they take the cash proceeds and lock up an amount equal to their future obligations of principal and interest and spend only the Manna? They are being given those three options by the ECB. Whatever way is chosen it’s an incredible test of the inclinations of government to act responsibly and address the debt problem or keep on spending and borrowing.

Fifth, irrespective of governments’ use of the Manna, there is a balance sheet effect for the government whose debt is purchased by its own central bank.

As an aside, when the ECB as a policy board orders a buy of a country’s debt, it is purchased by the country’s own central bank. (Yes, the individual country central banks continue to exist even though there is an ECB. The individual country central banks are the operational banks within the Euro system, as are the 12 Federal Reserve Banks carrying out Federal Reserve policy.)

Now, if a Euro central bank purchases its own government’s debt, it defeases (annuls) that debt. A balance sheet defeasment occurs when the government and its central bank balance sheets report on a consolidated basis. The debt of the parent organization (the government) is owned by its subsidiary (its central bank) and, as a result, only net debt not owned by the subsidiary can be reported. Indeed, the U.S. now reports government debt outstanding on a net basis to mollify those concerned about government debt balances.

Sixth, the ugly government debt problem disappears (on a net basis) when central banks buy its sovereign’s debt and pays monetary premiums for it but, in its place, there is a classic fear that there will be an inflation tax. That is a real reduction in the value of fixed income assets held by the public due to inflation. This is a fear that is totally justified despite today’s weak and deflationary-prone environment, as the increase in the monetary base would be very, very large.

For example, in the U.S., if the Fed were to monetize the total outstanding $18 trillion of U. S. government debt, and with some premium paid above that amount equal to the ECB premium, the total monetary base would easily go above $20 trillion. This compares to a monetary base of $0.8 trillion at the outset of the Great Recession. That would cause a 25-fold or 2500 percent increase in the money base as compared to a cumulative 13 percent increase in real output over the same period. It might take some time to play out but this will certainly lead to inflationary devaluing of fixed income assets and currency and result in capital flight to a more stable medium of exchange.

This is no way to run a government and its finances if a country expects the world and its own citizens to hold wealth denominated in its own currency. Indeed, it is second-best policy not just due to the inflationary potential but also as a result of undermining insurers, pension funds, banks, and endowments to perform on their obligations. Furthermore, negative yields create a poverty class of retirees, of which there will be many.

But somewhere between zero defeasance and total defeasance of government debt is likely to be a better place for debt overloaded countries, giving them the option to use the proceeds to retire rather than squander the proceeds or give in to the incentives to borrow and spend even more.

Manna from Heaven, on its face, can be helpful if done on a very limited and disciplined scale, but when have we ever seen governments do that? The Manna becomes a litmus test of governments’ inclination to act responsibly and effectively, as it could either defease debt or be incentivized to add to debt.

At best it can only be a small help as compared to policies to unleash the supply-side of the economy to generate growth that will sustain the developed world’s debt problems.

Given all this, we find that the monetary sleight-of-hand to produce Manna only goes so far before producing unwelcomed side effects. It’s not a replacement for containing debt within supportable limits. All in all, John Maynard Keynes did a disservice some 80 years ago to suggest otherwise.

We must conclude, the rules of propriety have changed. Many naïve among us believed that when governments borrowed they intended to subsequently tax in order to retire debt. But at least it was thought that taxes would pay interest to service the debt. This too has proved to be a false premise as central banks drive interest rates to zero or negative to accommodate over indebted governments. And now in the final assault on propriety, governments are being paid by central banks to issue yet more debt.

The Point of No Return for Government Debt

Economic growth in the developed world is falling well short of the post-WWII experience, and there are identifiable causes.

Globalism — the opening of global trade — has caused developed economies to lose exports to lower-wage emerging nations and is but one factor. Another is the slowing of population and labor force growth (and, in some cases, both are shrinking). This contributes to the problem of slow economic growth as it restrains both aggregate supply and demand.

Furthermore, when populations stop growing, what outpace economic growth are age-related government entitlements as the age-profile of the population becomes top heavy with retirees. This, in turn, means taxes rise disproportionately on the backs of the relatively fewer workers, or the country — more realistically — resorts to debt financing.

Entitlements accelerate the accumulation of government debt now being piled on top of decades of Keynesian deficit spending that were an attempt to nudge higher growth rates.

It has long been a vague concern that government debt accumulation would be the ruination of an economy, and that sovereign defaults would occur as they have many times in that past. That issue is now front and center in both Europe and Japan, with the U.S. perhaps a decade behind.

Larger debt loads, however accumulated and whether from Keynesian economic stimulus, entitlements, war financing, or financial guarantees, cause tax rates to be higher than would be otherwise be necessary to pay yesterday’s incurred interest. It becomes a struggle for a government to merely pay interest without the possibility of retiring debt.

For example, in Japan, the debt-to-income ratio is a staggering 250 percent. This means that despite very low interest costs on government debt, 43 percent of tax proceeds are devoted to paying interest on its past debt.

Raising tax rates to pay debt service impacts the present as it becomes a negative incentive for investment spending. So past debt retards today’s economic growth.

The great danger of a high debt-to-income ratio is that it becomes self-reinforcing: We induce higher debt ratios not only via higher taxes to pay interest but also because the resulting economic slump unleashes Keynesian automatic stabilizers that have been built into an economy’s spend-and-tax reflexes.

As an economy’s growth rate slows, this kicks in income maintenance programs like unemployment support. At the same time, a slumping economy’s tax revenues erode more than in proportion to the slowdown in economic growth, which is a by-product of a progressive tax structure.

For example, in the first year of the Great Recession, U.S. government debt expanded by 15.8 percent while income declined by 2.8 percent, and together they ratcheted upward the debt-to-income ratio.

The economic slump produced by debt adds to government deficits resulting in yet more government debt and more taxes, which in turn reinforces the slump. The causation runs both ways: debt slows growth, and slow growth widens country deficits and accumulates debt.

What is being described is a self-reinforcing endogenous debt accumulation process in which the debt-to-income ratio rises until it can no longer be financed, resulting in a sovereign default.

The critical threshold when the self-reinforcing process of debt accumulation outpaces income growth has been aptly called the “bang point” by Reinhart and Rogoff (R & R). Their research, contained in their book “This Time Is Different,” shows that over many years, for many countries, that the threshold for debt to grow exponentially occurs when the debt-to-income ratio reaches approximately .9 — that is, when a country’s debt is 90 percent of its GDP.

R & R find that on average, for many countries, when that threshold level of the debt ratio has been reached, economic growth becomes retarded by 1 percent. In today’s world, much of Europe (and certainly Japan, too) is well above that point, and income growth has certainly declined and is barely positive.

For the U.S., at a debt-to-income ratio of 100 percent, economic growth is also being sucked into the endogenous web of debt in which, at best so far, GDP growth appears to be have been retarded by 1 percent annually.

The U. S. finds itself this year in a relatively weak cyclical upswing in which the growth of income and debt are both rising at approximately the same 2 percent rate so that the debt ratio is being maintained at the present time, but any slump in growth accelerates the debt ratio.

As a deterrent to debt accumulation, a heroic attempt is taking place in Japan and the U.S. to reduce the interest expense of government debt. Europe, via its European Central Bank (ECB), has recently engaged in a similar battle.

The debt service reduction is being described as Quantitative Easing and is being discussed and sold to the public as being a monetary policy to offer lower interest rates to stimulate interest rate-sensitive private spending. That is, low rates to stimulate growth.

Indeed, many of the central bankers are well trained Keynesians and they think that way, but to the political class, the central bankers are used as pawns to neutralize the government’s debt burden.

There is much debt service to be neutralized at current levels of debt, especially in Japan and Greece. What greatly complicates the problem of maintaining debt service with a high debt ratio is that the government bond market, when it senses that the debt problem is getting out of control, will only finance the government’s debt with elevated interest rates that imbed a sovereign risk premium.

To get a sense for a country’s interest cost exposure to sovereign default pricing, take a simple example of a debt-to-income ratio of 1 and an (unrealistic) interest expense that averages 1 percent on all government debt issues. In this case, taxation would only need to capture 1 percent of a nation’s GDP to service country debt. This expense is manageable.

But to be more realistic, sovereign bond yields on 10-year debt maturities are shown below for several different recent European sovereign bond market eras.

Prior to the common currency that arrived in 1999, when the Euro countries were on their own (in the sense of no support from by each other or by a central bank), sovereign yields were priced to reflect sovereign risk.

At the start of the common currency in 1999, the sovereign rates came together at Germany’s base rate during the honeymoon of the Euro zone when it was presumed that the stronger countries would come to the aid of the weaker if need be — and if not, there was a central bank to provide assistance. Also debt control was a pre-requisite to be a member of the Euro zone.

This presumption of aid to the weak became questioned after the financial crisis, and there was a weakening of country debt control. This relevant era began in 2008, at which time the market priced country vulnerability with little or no help from neighbors or by the central bank because “monetary finance” (or central bank financing of governments) was still taboo.

That environment reveals clearly how hard markets will punish sovereigns with debt problems. High single digit sovereign yields existed, and Greece, which was headed for its first default, experienced a 30 percent market cost of finance for 10-year maturities.

In this case, for a country with debt equal to 250 percent of annual GDP, and if its sovereign average cost of funding for all maturities was merely 10 percent, that country would need to capture fully 25 percent of GDP to pay interest alone without any of the other costs of government being covered. There would be debt cost of that magnitude likely for both Greece and Japan.

That is the process by which default is brought on when the debt-to-income ratio reaches the bang point. It might take a few years, but the process grinds on until the income lost attempting to tax and service the debt becomes impossible to bear.

So, in a last ditch effort to avoid default, the central bank intervenes with quantitative easing to reduce interest rates paid by sovereigns. QE is in process in Europe, but as things currently stand, Greece’s sovereign debt is not investment-grade and, hence, is not eligible for purchase by the ECB unless the rules are bent or the rating is changed which is a likely response in the pragmatic business of saving the sovereign, otherwise known as “Whatever it takes.”

Alternatively, Greece would need to drop out of the currency union, likely default on its debt in whole or in part, and go back to its own currency from which they can continue to play the money game to depress interest expense. In the case of Japan, the pretense continues, but they are past the bang point and — short of some new exogenous source of demand for their products revealing itself — they are sinking deeply into the morass of debt and debt service.

But will central bank QE really contain the debt service problem? The answer has to be no because the side effects of the debt solution becomes its own problem.

With such low investment returns in-county, capital flees to higher-yielding locations and, without capital, there is no financing of private investment and the real physical capital stock becomes a relic of yesterday. This erodes income and raises the debt-to-income ratio further.

Once having reached the bang point, QE is too late and counterproductive

Oil Boombustology

It’s long been in the DNA of economists and market observers, going back at least to the Austrian School of Economics, that when money growth outpaces the economy’s growth, booms are created and so are busts: Boombustology, as coined by Mansharamani of Yale University.

Certainly quantitative ease as practiced in serial form by today’s central banks fan that concern, but for the most part, the sentiment of central bankers, politicians and the market seems to be “please let there be a boom” and we’ll dodge the bust.

There are all kinds of booms and busts. Some are of a benign form called behaviourism. They are born of the belief of ever-increasing prices. Tulipomania during Holland’s seventeenth century was a classic. Though it might not carry an entire economy into excess but the rise and fall of tulip bulb prices surely redistributed wealth.

But some booms involve financing to purchase the item that is booming whatever it is. In that case lenders also have to buy into the boom to make it happen. When the item booming requires industrial equipment to produce it, the economic ripples become far reaching.

The boom mood creates over-building of the capital goods and eventually, the oversupply of the booming item whether we call it tech, housing or commodities. Then, the rising price of the item that precipitated the borrowing and building turns into a free-fall of prices, borrowing and building. There follows an air pocket of demand for the capital goods in question which can then become a generalized demand suppressant and a financial bust.

The lethal combination of reduced demand and over-supply brings into play all the D Words: deflation, default (on the financing), depressions if wide spread and possibly devaluation of the currency, if capital flows to safer ports of call.

Certainly the Great Recession was deep and long not just due to the overindulgence of borrowing and home building but also the permanence of the physical structures left behind that creates a following air-pocket of demand in some places called Ghost Estates. That is, the durability of the over built real capital determines the duration of following depressed demand and soft prices. And this condition continues and defines the duration of the bust as long as the excess supplies are a silhouette on the horizon as shown to the right.

In contrast, was the boombustology of over-built agricultural capacity during World War I to feed a world at war. At the war’s conclusion, Europe went back into production and this expansion of U.S. agricultural capacity created a supply glut in the commodity markets when Europe went back into production. But given the short life span of the crop and the ability to cut back production, the US deflationary depression of 1920-21 that followed was short, sharp and self-correcting.

In today’s post Great Recession environment, fear still persists that the economic ship has not been righted. The duration of a housing bust has been long given the duration of the over-built houses that still dot the landscape in some places.

Central banks are reluctant to take their foot off the proverbial gas pedal and, instead, push the pedal to the metal. And they, still with faith in the Keynesian multiplier, apply ever-cheaper credit (if that is any longer possible).

So where has the money induced boom arising out of the central banks QEs been hiding? To pick up the trail, all one needs do is follow the deflating prices of what is over-built. That leads us to oil, and much the same can be said about commodities in general, especially in the emerging nations.

During the boom phase in the U.S., oil drilling and extraction have been highly instrumental to the U.S. cyclical recovery.

The oil boom didn’t quite take the overall U.S. to a giddy boom, unless you were in Texas or North Dakota or a few other states but its contribution to spending of $300 to $400 billion per year has been the difference between a 2 percent real growth rate and an economy being dead in the water.

Furthermore, as reported by the Manhattan Institute, the economy’s employment growth has been highly concentrated in the oil and gas industry (with other sources of employment growth barely moving the employment needle).

As it turns out, the shale oil industry mainly via the energy investment banks of the region financed over $1 trillion — or an amount equal to approximately 40 percent of Fed-provided liquidity during the Great Recession.

Bloomberg reports that there was $353 billion of IPO in the industry, $286 billion of joint ventures, and $786 billion in lower rated bonds financing this capital intensive undertaking.

Now the oversupply of oil from their success has turned against the drillers. The U.S. marginal increase in oil and gas production to global supply along with generally softening economies in the developed world has caused oil prices to decline in the neighborhood of 50 percent. This boom is now in the bust phase, and additions to production are in retreat.

This represents a world of hurt for the investing entities (generally small firms) and their employees as well as those who hold the energy securities in the form of low-rated bonds or commercial bank loans. Fortunately, the amount does not threaten the mainline financial institutions that hold only a small portion of them, so the financial bust is confined but the physical remains of the boom are silhouetted on the landscape as shown above.

But there is a silver lining to this boombustology. For one, the active life of a fracked well is in the neighborhood of two years during which time 90 percent of product is extracted. The short duration of the income stream from fracked wells allows for a smoother adjustment on the downside and re-fracking will only continue if supported by price increases.

But more importantly, the 50 percent price decline for energy which is used by all other sectors of the economy is provides a large cost savings that is equivalent to a tax cut. Moreover, for the corporate sector, the cost savings represent an increase in net cash flow and higher profit margins and hence broad market support for both stocks and bonds.

But the real issue is will the economy shift gears and sustain the growth of recent years in the absence of an oil thrust? The now-50 percent increase in bank lending to commercial and industrial uses since the bottom of the Great Recession in 2009 along with the “energy tax cut,” suggests that the usual mechanisms of monetary policy are beginning to work to sustain economic expansion beyond oil and commodities.

There are all kinds of booms and busts, and this one could well have a silver lining of generalized higher income after energy costs across the landscape, without a generalized financial meltdown. All in all, the oil and commodities booms and lower prices, even with their industry losses have a net positive effect on economic growth, all things considered.

So, on the spectrum of booms and busts this one will likely be more in the category of the self-limiting agricultural deflationary depression of the early 1920s than the housing boom and bust of recent memory.

Indeed, it has been sufficiently underway to cause the Fed to state its intention to end its quantitative ease. Furthermore, now that there is a stated intention to shift to a monetary tightening, it raises the question of what is left of growth in the US economy without oil expansion? The oil and commodity bust leaves us with a tilt toward deflation and an expansion that remains to be seen.

Goodbye to the Robinson Crusoe Bond Market

With the U.S. economy having achieved lift-off momentum, the Federal Reserve has ended, at least for now, large-scale bond buying — better known as quantitative easing. Furthermore, the Fed is taking a big gulp and is working up its collective courage to move to interest rate “normalization,” if anyone can remember what that is.

The thinking is that by merely removing the Fed’s large-scale demand for U.S. Treasury bonds, those prices would revert to whatever private buyers will sustain. And with less demand and lower prices, we would get to the correspondingly higher market interest rates. If so, this would be the normalization of rates on autopilot, as no further Fed action would be needed.

That intuition is so strong that a recent Bloomberg survey of economists showed they forecasted not just higher interest rates for 2015 but also that the 10-year T-Bond yield would rise from its year end lows of near 2% back to the 3% level as it was in the beginning of 2014 (shown below).

Moreover, not only was this the economists’ consensus, but all participants forecasted higher rates in defiance of the multi-year downward trend, including last year. It is indeed a rare event when economists’ forecasts are not merely a trend extrapolation but rather based on deeply ingrained training and historical experience.

The intuition behind this forecast is, no doubt, based on the classical idea that absent a Fed intervention, market demand rests solely on the shoulders of motivated savers and with the bond sell-side being dominated by businesses that offer bonds up to the point at which their borrowing cost is just supported by investment returns to real capital.

For the sake of argument, let’s call this the Robinson Crusoe island world of finance. It’s quaint, uncomplicated by government actions and constraints, and all bond buyers and sellers are domestic investors. It is the veritable island economy without a central bank.

However, with the advent of globalism, government buying and selling, and regulatory manipulations of all sorts, market-determined interest rates have moved to a new setting. With the elimination of capital barriers, the global financial industry can now move capital across borders for many purposes and reasons and, in so doing, move U.S. financial prices. Of all markets that are not islands, it would be the U.S. Treasury bond market that is still the main holding for other countries’ external reserves and global investors’ go-to asset.

The U.S. 10-year Treasury bond is nearing a 2% yield, and while that is very low both in absolute terms and by historical comparison, it is much higher than similar 10-year government debt in a host of countries that matter.

With Germany at 50 basis points, Switzerland and Japan at 30 basis points, and even troubled Spain at 60 basis points, these countries make the U.S. 10-year T-bond’s 200 basis points very appealing, especially when the U.S. dollar is appreciating against other currencies.

And then there have been institutional developments and a regulatory framework that influences asset choice. Accumulated consumer savings now reaches the demand-side of bond markets via pension funds, banks, wealth managers, and insurance companies where interest rates reflect many categories of private risk. The one that stands out most is the fear of deflation taking place in Europe and Japan and with falling oil prices in many other places as well. This biases the demand toward fixed rate financial contracts in the strongest currency.

Bingo, dollar-denominated Treasuries win again.

And then there are other contortions to market demand for Treasuries when fearful regulators weigh the default risk of different assets in an institutional portfolio and assess a charge in the form of risk-weighted capital. And, as you might have guessed, U.S. government regulators assume U.S. Treasuries are absolutely riskless and, as a result, no institutional capital need be set aside for owning Treasuries as compared to private debt.

Well, the recent push for more stable and capitalized banks suddenly makes the U.S. Treasury asset class more desirable for regulated institutions even at extraordinarily low interest rates because U.S. Treasuries provide capital shields in addition to their puny interest rates. As a result depository institutions have added over $120 Billion to their portfolios in the last three years.

And then, as discussed last month, there are the central banks of the rest of world. They are lining up to buy U.S. dollars (and in turn U. S. Treasuries as a foreign exchange reserve) with their own printed currency. This is a bi-product of the “currency wars” for the purpose of depressing the relative value of their own currency in order to recapture lost global exports.

Just behind the official foreign government purchases are the foreign private investors that are sucked into US dollar assets as a result of the twin appeal of higher U. S. yields and the US dollar appreciation that is occurring relative to 31 currencies. None of this was ever seen in a Robinson Crusoe bond market.

And this phenomenon is likely to kick into higher gear shortly as the European Central Bank (again) reassures its constituents that it will have a QE of its own. It will be directed to Eurozone Sovereign bonds in the first instance, but with Euro domestic yields already so puny, the expectation of a Euro QE is already causing private investors to redirect their wealth away from Euro investments into higher yielding, dollar-appreciating U.S. Treasuries.

As you look up and down the line-up of players and motivations, interest rate normalization will not likely take place by the Fed simply sitting on the sidelines of the Treasury bond market. There are too many other sources of Treasury demand in this divergent, deflationary, regulated economic world causing T-Bond demand to wash up on our shores. Rising rates attained on autopilot, as a result of the Fed’s ceasing to be a buyer of Treasury bonds, will not be enough.

So then if rates were to return to historically normal levels, it’s likely to require not just a hands-off autopilot approach by the Fed but also that it enter the market as a seller of U.S. Treasuries (and if not Treasuries, then something else). That would be a reverse QE, if you will.

And it’s possible that the Fed doesn’t have enough 10-year Treasuries on its balance sheet to sell to drive the price downward in the face of these motivated foreign buyers. But it does have a larger supply of shorter dated Treasuries that can be sold. Additionally, by raising the rate that it lends to banks, it can drive short rates higher and pull some private demand out of the long-dated Treasury market, effectively leading to a yield curve flattening.

In general, it’s a good bite easier for central banks to drive bond prices upward by turning on the printing press and buying something in large enough quantity so long as they do not run out of paper and ink. But to directly lower prices of a financial asset, it needs a sufficient inventory of the item to sell.

There are other manipulations possible to push rates higher: the Fed could raise the cash requirement of commercial banks to take bank-allocated funds out of the treasury market and even force commercial banks to shrink their balance sheets. But this runs counter to all their efforts during the Great Recession and seems unlikely.

And then there is the new, interesting weapon in the Fed’s arsenal to raise rates: sell Federal Reserve debt. That would be a refinancing of the Federal Reserve’s liabilities side of its balance sheet. Sell Federal Reserve bonds that are paid for by Federal Reserve Notes (cash). But does the Fed have the statutory ability to sell Federal Reserve debt? Well technically no, but it has been engineered around to functionally do so.

The Fed has entered the “Reverse Repo” market, selling claims collateralized by its U.S. Treasuries holding, of which it has an abundance on its balance sheet. This end-run provides the same result, and the Fed has been running about $200 billion as an experiment of the technique. Allowing the Fed to issue bonds or interest-bearing debt is a novel idea to suck some of the cash out of the system, and it has finally come to fruition. In this complicated global world, it needed an additional instrument of market control.

So whether or not the market self-corrects to the Fed’s interest rate target, it can still achieve its objective. But it will not be Robinson Crusoe on autopilot.

The interest rate environment is not what it used to be in the good old days of a closed country home central bank monopolized game. Now there are other central banks effectively creating monetary policy in U.S. markets.

Achieving policy objectives in a global financial system is a far more difficult, multi-faceted problem when foreign flows, both private and governmental, offset the domestic policy dictates. The Fed is no longer all-powerful over U.S. markets.

Slow or chronically weak economies with deflation and with foreign governments hell-bent on achieving export share are causing financial spillover into the U.S. market that would be difficult to offset, leaving the future course of longer maturity Treasury yields a major question. Rising rates would depend on how determined the Fed is for normalization, even if it has to sell a lot of something to mop up excess currency.

Welcome to the Brave New World of domestic policy constrained by open global financial markets. Robinson Crusoe would hardly recognize it, and for that matter, many Fed Governors don’t recognize it either.

The Deflationary Trap and the Central Bank Game of Chess

My financial start in life came in the 1970s when rent houses seemed to be a good idea. That was because its rental stream was ratcheting upwards in an inflationary environment and could also be acquired with its original fixed-rate mortgage still intact.

What made the investment especially appealing was that the inflationary wind was to my back; rental streams grew while the mortgage’s interest carry remained low and locked at a fixed rate that reflected earlier and more modest inflation.

And as you might think, the combination of inflation-enhancing income streams and cheap fixed rate financing is an environment that promotes the building of more of the same — not only more houses but more importantly corporate plant and equipment that grows jobs and output. Hence, economic performance benefits from inflation, to some degree.

A return to these conditions is what central banks of the world, especially in Europe and Japan, lust for today. Instead, they find themselves on the edge of exactly the opposite — a deflation that neutralizes the benefit of the low fixed rates that central banks have manipulated since the onset of the Great Recession.

But one must appreciate the full extent of the deflationary threat facing many developed countries today that drives policy and markets.

Deflation more than neutralizes the low interest rates provided by central banks because investment in real physical assets is deterred by the prospect of deflating income streams. And that reduces spending on new physical assets which, in turn, reinforces the deflationary environment.

That is, while deflation may be the product of previous soft economic conditions, it inhibits further physical investment in real assets thus reinforcing the existing deflation.

This is known as the deflationary trap.

And that’s not the end of the self-reinforcing deflationary damage. Deflation also shrinks top-line income of the corporate, government, and consumer sectors which diminishes spending and in turn makes it more difficult to repay existing debt. In other words, the real value of debt increases leading to default and default takes down not just the borrower but also the lenders.

The iconic scenes of bank panics of yore in which depositors line up to withdraw their funds tell a story. The depositors believe deflation induced defaults in the banks’ loan portfolios will cause the banks to fail and they had best retrieve their deposits while they can.

The dynamic leaves the banks not only with loan losses but no lendable cash. It still plays out today though not as visibly as deposit withdrawals are on-line as in southern Europe.

That was the story of the l930s.

If both the desire to borrow and the ability to lend go away, the wheels of an economy no longer function in the way we are accustomed, no matter how much money supply the central bank spreads around.

Since the developed countries are on the edge of the deflationary trap, many of their central banks are resorting to quantitative easing (QE). These epic asset purchases do not produce the lending and spending or inflation that monetarism suggests, nor do the QEs reduce interest rates, as they are already at the near-zero floor. Rather, in a great Hail Mary, the QE at this stage is intended to devalue the home currency so that domestic produced goods become relatively cheaper for foreign buyers and they do buy more.

That is the motive for quantitative easing — to gain greater global market share through a cheaper currency and hence goods, which is all that monetary policy contributes these days.

While selling currency on the foreign exchange markets is the direct route to a cheaper currency as practiced by China, it goes against the rules of central bank monetary chess. So the currency selling needs to be more subtle.

The preferred way to accomplish the same is a QE of large-scale asset purchases of domestic financial assets. The central banks claim its domestic monetary policy and leave it up to private investors seeking higher yield to head for the financial markets of other countries where slightly more than microscopic yield still exists.

In the process, the investors heading abroad sell their currency and cause the currency devaluation and do the dirty work for the central bank. It’s not much of a cover-up, but it’s what central banking has come to be these days.

What other reason would cause, for example, Japan to roll out yet another QE in heroic proportions and then, less than a month later at the news of yet another Japanese recession, to increase its very recent QE by 33%?

If successful, a cheaper Yen attracts foreign buyers of Japanese goods and enough demand to turn deflation into inflation that generates inflation streams for home-grown investment in physical capital. It also gives domestic producers pricing power, when the prices of imported goods rise in terms of the Yen.

So the self-reinforcing deflationary depression leads to often contentious policies of currency devaluation via investors in an effort to capture greater global market share and some modicum of inflation. The Fed’s QE3 of the previous two years that ended last month paid dividends for the U.S. in this game at the expense of Europe, Japan, and others, which, in turn, triggered their re-entry into the currency wars just as the Fed ended theirs.

Other countries are now in retaliation mode in this game of central bank monetary chess, hoping to steal some demand back from the U.S. This leads to not just the depreciation of their currency but the ascendency of the U.S. dollar and the value of U.S. assets, which was nice at first until we find out it’s gained at the cost of a now-perceptible slowdown in the U.S. economy. In this stage of the currency wars, the U. S. is about to lose some of what it previously gained when the Fed was in QE3 mode.

Hence, quantitative easing is no more than a cover-up for currency devaluation: it allows government officials to claim their hands are clean from a practice that is globally frowned upon.

In the process, central banks have revealed that money growth is not the inflationary threat once thought, at least not in this environment. We have come to the understanding that in the deflationary trap, neither fiscal nor monetary policies are what the textbooks say they are.

Public policy has come down to the sorry state of manipulating growth and inflation at the expense of someone else’s deflation. It’s a zero sum game of redistribution among countries that adds little overall lift to the global economy.

Few who lived through the “runaway” inflation of the 1970s would have dreamed that someday inflation would be a desirable public policy? We have come to find out that it surely beats deflation. But how to achieve inflation has proven to be elusive when lenders are fearful of deflationary induced default and business investment borrowers need more inflationary wind to their back.

The Spellman Report

The Spellman Report, Where the Economy and Markets Meet

Tag Archives: Economy and financial market pricing