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Economics

The Private Equity Boom, Easy Money, and Crony Capitalism

[Editor’s Note: this piece, by Brendan Brown, first appeared at http://mises.org/library/private-equity-boom-easy-money-and-crony-capitalism]

Amongst the big winners from the Obama Fed’s Great Monetary Experiment has been the private equity industry. Indeed this went through a near-death experience in the Great Panic (2008) before its savior — Fed quantitative easing — propelled it forward into new riches. There is no surprise therefore that its barons who join the political stage (think of the last Republican presidential candidate) have no interest in monetary reform. And the same attitude is common amongst leading politicians who hope private equity will provide them high-paid jobs when they quit Washington.

The ex-politicians are expected by their new bosses to join the intense lobbying effort aimed at preserving the industry’s unique tax advantages (especially with respect to deductibility of interest and carry income) whilst establishing the links with regulators and governments (state and federal) that help generate business opportunity for the varied enterprises within the given private equity group. The special ability of these to take advantage of the monetarily induced frenzy in high-yield debt markets and secure spectacularly cheap funds means they become leading agents of malinvestment in various key sectors of the economy.

What’s Makes Private Equity Run?

Spokespersons for the industry claim that the private equity business is all about spotting opportunities to take over already established businesses, and then using home-grown talent (within the private equity management team) to transform their organization so as to create value for shareholders. And this can all be accomplished, they say, without the burden of frequent reporting requirements as in public equity.

That is all very laudable, but why all the leverage, why all the political connections, and why all the tax advantages? And even before getting to these questions, why should we praise the secrecy? After all, public equity markets are meant to do a good job of incentivizing and disciplining management, especially in this age of shareholder activism, so why is private equity superior?

Perhaps there are instances where companies which are now in the public equity market cannot economically justify the fixed costs of maintaining their presence there (filing reports, auditing, etc.) and there is a net gain to all from being taken private. In practice, though, this public-to-private conversion function of the private equity industry has been dwindling in overall significance compared to private-to-private acquisitions and new ventures.

Why There’s So Much Leverage

But why should there be so much leverage? Why could their economic functions not be achieved on a purely or largely equity basis?

After all, there are reports of private equity groups turning away would-be new participating partners offering to bring in zillions of new funds to the party. If individual investors in private equity wanted high leverage they could do this on their own account without saddling the particular enterprises with large debts.

The obvious answer to this conundrum is that the private equity groups are in fact risk-arbitragers (and tax arbitragers) between what they view as greatly over-priced high-yield debt markets (sometimes described as junk-debt markets) and less overpriced equity markets.

How Easy Money Enables Private Equity

The Great Monetary Experiment has induced such a plague of market irrationality characterized by desperation for yield that the price of junk has reached the sky. On top of this, the US tax-code incentivizes such arbitrage by allowing full deduction of interest from corporate profit. Why are some affiliates of private equity groups buying the junk? Perhaps that has to do with the benefits to be derived in the event of any particular enterprise owned by the group filing for bankruptcy. The private equity group would be in a better position to negotiate a debt-equity swap if it is on both sides of the deal.

The name of the game is achieving as high a leverage as possible and nothing brings success here like success. Specifically, as private equity investments have produced a series of great returns in recent years — as indeed we should expect from highly leveraged strategies in a powerfully rising equity market — the speculative story that their managers really have talent has attracted more and more believers who are willing to back it with their funds. One aspect of this has been the ability of private equity groups to leverage up their businesses to an extent never previously achieved as the buyers of their junk debt believe that unique talents of the partners and their managers make this acceptable. And the cost of equity to the private equity groups falls as a wider span of potential partners believes in their power of magic.

The Crony Capitalist Connection

The new business ventures on which private equity has concentrated in recent years are often in areas where regulatory or political connection is important — whether in finance, real estate, energy extraction, or providing health-care facilities. A private equity group buys the advantages of “connections” (otherwise described as cronyism) for all the small or medium-sized enterprises operating within its fold. If each one were to build up its connections independently that would be much more expensive per unit of enterprise capital.

Hence one essential feature of private equity is the taking advantage of economies of scale in cronyism. And the tax advantages secured by political connections are crucial to the private equity model. The case for a reform of the tax code which would lower the overall rate on corporate profits but end the tax deductibility of interest is strong. But how could this ever make headway against the private equity industry and its deep roots in Washington, DC?

Private Equity, Shale Oil, and Other Bubbles

In thinking about the downside of private equity for economic prosperity there is much more to consider than stalemate on tax reform. There is the specter of the infernal combination of monetary disequilibrium and cronyism producing huge malinvestment. That picture is already emerging in the shale oil and gas industries where private equity with its highly leveraged structures has been prominent. Elsewhere, the finance companies spawned by private equity and outside the ever-more regulated traditional bank sector. These have played a lead role in rapid growth of sub-prime auto-loans which have contributed importantly to the boom in vehicle sales. Private equity owned leasing companies have outsmarted their competition to provide enticingly cheap terms to aircraft carriers especially in Asia and helped fuel a tremendous boom in sales by Boeing and Airbus. Private equity participation in letting apartment blocks has helped fuel the mini-boom in multifamily housing construction.

This is all fine whilst folks are dancing to the music of the Great Monetary Experiment. But what will happen when speculative temperatures fall across a wide range of markets presently infected by asset price inflation, including high-yield debt, equity, and of course private equity? We know much though not all about the disease of asset price inflation from the past 100 years of fiat money experience under the leadership of the Federal Reserve. Each episode of disease is different but there are common elements. One of these is a deadly end phase featuring plunging speculative temperatures, great recession, and the revelation of huge capital squandered in previous years. The private equity story is new, but there is nothing new under the sun.

Economics

How did we end up here?

While money can be made in markets on the minutest of scales, sometimes it helps to have a broader sense of perspective. After all, if you can’t locate yourself on a map – without the aid of GPS, children! – you don’t know where you are and if you have no grasp of history, you don’t really know who you are either.

15-01-31 IMF ALL (2)
Courtesy of Bloomberg

So, focusing on commodities in this instance, we here use the monthly IMF price report to construct an overall index composed of energy, ags, base and precious metals by blending them with the typical sort of weightings favoured by the major tradable indices of today.

As can be seen from the graph, commodities – priced in the dollar of the day over the last four decades of floating exchange rates and unanchored policy – form a neat, symmetrical pattern when plotted on a log scale (on which equal percentage, not arithmetical, moves have the same length). At the bottom left lies the substantial, two-stage rise in prices which finished by defining the upper and lower bounds of what would turn out to be a 33-year central value area, This took place, as needs little recounting, over the course of the two Oil Shocks of ’73-4 and ’79-80.

A long decline followed that first peak, one punctuated both with the 1986 oil crash – from which many are drawing a chastening lesson today – and with the spike which attended Saddam’s invasion of Kuwait and the First Gulf War, before the move came to an end in the chaos of the 1998 Russian bankruptcy and the climax of the shattering Asian Contagion.

From that nadir, we have lived through the so-called ‘Super-Cycle’, whose salient features were the run to near $150/bbl oil in 2008, the ensuing financial collapse, and the Great (Chinese-led) Reflation which followed. Three years were spent zigzagging lower in a narrow corridor thereafter – during which ags hit their highs, metals ground ever lower, and silver and gold each made record highs before going into their own, separate tailspins – then came the dramatic, front-led breakdown of the energy complex, the last resort of the commodity bull to that point, a man who luxuriated complacently in a narrowing range, falling volatility, and a then-remunerative inverted (‘backwardated’) forward curve.

From here, the question is whether the current uptick is any more than a bout of short-covering which is doomed to relapse and print new lows once the overstretch inherent in an almost uninterrupted 60% plunge is worked off, or whether some more meaningful recovery can be staged. We still have our doubts about the latter outlook and would watch for behaviour near the 2009 low and the old range high (or in terms of the most heavily weighted of the constituents, crude oil, whether it will hold above first $40/bbl then $35).

If not, we face the possibility of a reversion to the mean/mode of that 1974-2005 band at a level loosely corresponding to $20/bbl oil.

Courtesy of Bloomberg

Courtesy of Bloomberg

Of course, the foregoing discussion has all been conducted in nominal terms – that is, without allowing for the general decline in the purchasing power of the dollars in which the index is measured (itself something of a tail-chasing concept since we calculate that same depreciation by looking at how much ‘stuff’ a dollar buys today compared with yesterday and some of that same ‘stuff’ is energy itself, so this recalculation inevitably contains an inseparable mix of relative and absolute prices changes).

We choose here to make the adjustment not in terms of that often rejigged and housing-heavy basket of goods, the CPI index,, but in terms of what that aristocrat of the labour force, the American manufacturing worker, can buy with an hour’s worth of his time on the assembly line.

Once we make the necessary reckoning, the long decline over the last quarter of the last century is thrown into an even starker relief. It also becomes clear that the rise from the secondary, post-9/11 low to 2011’s reflation peak lasted almost exactly as longas did the first great lurch higher and that it reached its apogee at almost exactly the same height as did its forerunner.

Here, we would note that, while trading below the 199o spike and/or its nearby fib level, the distribution’s mid and the 2008 lows look well nigh unavoidable from a technical perspective.

Courtesy of Bloomberg
Courtesy of Bloomberg

Having adjusted for the dollar one way, let us now do so in another. For the world beyond America’s boundaries, it matters not a jot if the dollar price of corn or cotton goes up by 10% if the greenback moves a similar proportion in the opposite direction in terms of the local unit of exchange. In order to isolate the history of price changes from the worst of this effect, the simplest – if very approximate – operation is to multiply the index by the trade-weighted value of the dollar and so we do.

Here, too, we can see how clearly delineated was the ‘Super-Cycle’ – i.e., that coincidence of China’s ‘opening up’ and the Europeriphery’s enjoyment of cheap German finance with a sustained spell of preternaturally low interest rates around most of the world (rates which now, of course, seem unattainably lofty!). the ‘Committee to Save the World’ has a lot to answer for!

We can also see just how decisive the last six month’s break has been and note that technicals, at least, offer little support for something still so historically elevated and presently so remote from any momentum-sapping area of well-populated precedent.

Courtesy of Bloomberg
Courtesy of Bloomberg

Finally, since only very few participants in our markets buy commodities for their own sake, but rather do so with a nod to the Modern Portfolio Theory superstition of ‘decorrelation’,  we offer up a graph of commodity prices (not returns) versus stock prices (not returns). Now it is the various highs and lows which seem to define an all-encompassing, downward-sloping channel of chronic underperformance.

Within this long, gloomy run, we can identify two periods of relative commodity glory of roughly equal extent and duration, spaced some thirty years apart. The first occurred during the Great Inflation which bracketed the break-up of Bretton Woods and the first fumblings toward its replacement monetary order, the Age of the Independent Central Bank (reverentially capitalized, of course). The second, one might contend, coincided with the end of the so-called Great Moderation which followed and – we would suggest – with the ongoing transition to a new and yet unspecified era wherein the follies and failings of our generation of manically-active, inveterately hubristic, printing-press central planners will be utterly repudiated in its turn.

Ask not for whom the Bell Tolls; it Tolls for QE.

Economics

One Leg to Stand on

Here’s a question for all the cheering QEuro fans out there. If you came across a country where both real and nominal money supply were growing at rates in the low teens – something its people had not experienced for almost a decade and close to the fastest seen in the last four – would you consider it to be a victim of ‘deflation’? If not, what help do you suppose an expansionary central bank would be to it?

Courtesy of Bloomberg
Really, Mr. Draghi?!?

 

Imagine next what would be the state of that nation if, in a five year burst of temporary insanity, it had it had contracted 2 ½ times as many bank loans as it had when it first went mad and that it had thus registered four times the net indebtedness (loans less deposits) as when it began– a deficit which nearly equalled the combined shortfall of its two largest neighbours put together, despite the fact that they were three times as heavily populated.

Now you might well suppose that, if such a thing could ever be advisable in such circumstances, the central bank could readily offer an effective incentive to carry the tendency further were it only to act to suppress interest rates across the curve.

But consider instead what would be the case if, after another five, nearly six, years of blood, sweat, toil and tears, that nation had rid itself of 30% of its loans, had added 25% to its stock of deposits, and had therefore shrunk its net indebtedness by an impressive two-thirds to return itself to where it was in relation to national income eleven years previously. If you were also told that households, having gone into hock to the tune of 28% net from an initial position of small surplus, were now, thankfully, back in credit, would you imagine that the plight of the saver might outweigh that of the borrower in the ordering of their priorities?

If so, you would be considering whether Spain should rejoice at Snr. Draghi’s latest coup de main or whether it should balefully consider that he was not only gilding a lily, but bedizening one from which the bloom had long since faded, into the bargain?

Courtesy of Bloomberg
The Prodigal returns. Spanish finances & liquidity improving

 

Nor might you sing Hosannas if you were Swiss or Danish since it is principally in those two peripheral nations that the overspill is most violent. Denmark has cancelled this year’s government bond auction schedule in a kind of QE by omission even as the central bank has continued to force interest rates deeper and deeper into negative territory – to the point where there are apocryphal tales being told of a people who are among the developed world’s most indebted being paid to take out floating-rate mortgages.

That will end well, if true!

As for the Swiss, it seems that the habit dies hard of putting the national balance sheet at the disposal of those wanting to short the euro at subsidised rates. We say this because, even though the €1.20 hard floor was abolished in the middle of the month, in the two weeks since, sight deposit balances have risen by some CHF44 billion – clearly a much higher run rate than during the preceding six weeks when a mere CHF29 billion was accumulated. The most that can be said for this is that the SNB has been improving its average (assuming the very strong hints of continued intervention are confirmed), getting euros on board at rates from CHF0.85 to CF1.05 so far and again depressing bond yields further below zero.

Courtesy of Bloomberg
Courtesy of Bloomberg

With Syriza trying to work out how far they can push a Union which would gladly be shot of them if that were not to open the infamous box of a certain over-inquisitive Greek lady; with Bepe Grillo still trying to engineer a referendum on the euro membership of his native Italy; Podemos pulling the aggrieved of Spain into the streets in their thousands; and the AfD having come out of their conference in Bremen all signed up to fighting the mainstream parties, not each other, the pressure will persist. There will be many trying to find a safer haven for all those shiny new euros with which Mario will be happy to furnish them so they can express their doubts over the course he is taking in cold, hard(er) cash. The Danes and the Swiss may therefore end up with rather more of them than they otherwise might wish.

If we look beyond this to the wider markets, we can see the ripples from the stone thrown in by the ECB spreading as far away as China where the press is starting to run stories about how disadvantageous the rise of the yuan is becoming for a nation tacitly hoping for a quick, external outlet for some of the unwanted goods which its heavily underutilized industrial base is all too capable of producing.

Coupled with the growing unease of some of those who have borrowed those ever rising dollars to dabble in the onshore market – possibly via the medium of one of those commodity plays whose collateral value is not exactly beyond question these days – this is beginning to test the mettle of the PBoC at its idiosyncratic daily fix (the one where it simply refuses to entertain any bids beyond the rate it has settled upon and so allows a recalcitrant market no outlet for its frustrations).

Though nothing definitive has yet occurred and even if, rather than breaking any key levels, the stock market is tending to churn up and down near the highs, one is hard pressed not to give in to the foreboding that the sands are shifting: that, grain by grain, the cosy consensus of the last several quarters is starting to erode.

Courtesy of Bloomberg
Courtesy of Bloomberg

Take for example the fact that the US market is beginning to lose some of the effortless predominance it has so long enjoyed. Indeed, that leadership – wherein a rising stock market draws in the capital with which to move the dollar higher while the rise in the dollar makes the equities denominated therein gain more ground on their global rivals – has been challenged these past three weeks or so to a 2-sigma extent not seen since mid-2010.

Courtesy of Bloomberg
Courtesy of Bloomberg

This reversal, though not yet so large as to magnify our nascent sense of alarm, does add to the suspicion that change is in the air. That said, however, some longer term projections do still allow for the possibility that stocks might yet press on to complete the current 3QE pattern which began with assistance from all three big CBs, back in late 2012, and so map out a full TMT bubble move before the reaction truly sets in (q.v., the Nasdaq Composite). So what we are presented with is another case of letting the market decide which way it wants to move before committing ourselves too heavily to one side or the other. Note, too, that this is a waiting game which itself marks a very different phase from the straightforward momentum chase of recent months.

Courtesy of Bloomberg
Courtesy of Bloomberg

If stocks are ambivalent, fixed income seems to entertain no such doubts. Even that bear market dog-with-fleas, the 5-year T-Note, is back to its lowest yield since the ‘taper tantrum’ while the next quinquennial slice of the curve has made record lows, narrowing the spread between spot and forward 5s by 175bps in three months to reach the lowest level of recent times. We can perhaps best observe the developments by a glance at the eurodollar curve.

Courtesy of Bloomberg
Courtesy of Bloomberg

But, far from placating the market, even the remarkable run of successive record lows in bond yields is starting to raise the eyebrows of many of those whose wills are beginning to be bent to the policymakers’ doom-laden croaking about the imminence of ‘deflation’. It would be amusing if it were not so serious: in order to justify their crass, hyperactive heterodoxy, the central bankers are having to scare the very horses they are simultaneously trying to lead oh-so calmly to water.

Another frequently cited storm warning is the 5-year forward break-even inflation reading as derived from the difference between vanilla and index-linked govvies. Your author must here confess to feeling this is far too arbitrary a number. We gauge the ‘inflation expectations’ which the authorities have insisted are key to judging the success of monetary policy from a spread – and now, worse, from a hypothetical forward spread which is the derived difference of two other arbitrary pairs of differences. Yet all this is reckoned in a segmented bond market subject to both institutional and regulatory imperatives, to vicissitudes of issuance, and to a vast official distortion made worse by the fact that, at very low nominal rates the reluctance to price the residual ‘real’ yields on linkers too far into the negative column is compressing the BEI spread between them – a phenomenon additionally exacerbated in the forward version by dint of the rapidly flattening yield curve.

WHAT DOES BEI ADD?   Courtesy of Bloomberg
WHAT DOES BEI ADD? Courtesy of Bloomberg

It would be wiser to bear in mind that just because we can define and measure the 5y5y break-even does not of itself imbue the measure with any genuine informational significance even if one cannot deny that it has come to exercise a certain lurid fascination in the mind of the market as well as in that of the official rate-setter.

Adding a further strand to this hangman’s noose, many of yesterday’s Peak Resource commodity bulls have undergone a temperamental slump which matches for its giddiness that of the prices of the industrial commodities themselves. Again, the spectre of ‘deflation’ has come to peer over our shoulder as we watch the tape.

Here we would only caution that the inferences people are deriving from commodity prices may not be as cast-iron (sorry) as they appear because it is not, in fact, so easy to disentangle the factors contributing to that decline in a world where we have so many broken pricing mechanisms in play.

Take crude, for one. Given the extraordinary growth in supply of which we have long been aware and given, too, the muted growth of (physical) demand in a world unable to shake off the shackles of the last boom, the presence of record long positioning in speculative markets at the end of July was a clear omen of doom, even if the timing of the sudden, catastrophic phase shift from a three-year sideways, ever-narrowing range to a runaway cascade was impossible to predict in advance.

All sorts of commodities in their turn have acted similarly over this last cycle; silver, gold, copper, tin, nickel, iron ore, rubber, uranium, minor metals, some ags, and so on – but the booms and busts have not all been coincident, a divergence from which we can infer that they are as much a story of a rolling wave of fickle, speculative over-exposure and subsequent mass liquidation as they are of anything to do with underlying, real-side economic factors at work in their use.

‘Doctor’ Copper is another commodity to which many outsiders like to refer, yet its medical credentials have been called into question by the huge distortions entailed in many years of shadowy Chinese malfeasance. What is therefore impossible to decide is how much the current slide relates to weaker contemporary real demand and how much is due to the unwinding of the greatly exaggerated, financially-enhanced, apparent demand from which we are presently correcting.

Again, the malinvestment bubble in mining itself was both enormous and – given the echo effects of loose credit firstly on selling prices and then on project finance – thoroughly comprehensible. But to move from diagnosis to prognosis, what we again have to ask is this: if we accept that there was a period of widespread over-expansion in the industry – albeit one formerly hidden by a credit-enabled take-up of the end product at ever higher prices – is today’s fall-out the same thing as evidence of a generally weaker economy, or is it just a belatedly more accurate reflection of what the state of that economy has truly been all along? The solution to that riddle, if one could reach one, would tell one whether the big losses to come will be confined mainly to the commodity sector itself or dispersed more generally across the equity universe.

What today’s reverse Malthusianism does overlook is the inarguable case that, if we made a miraculous scientific breakthrough tomorrow which unlocked what was an essentially limitless and near-free source of energy, we would all be unequivocally better off. Reasoning from such a Garden of Eden scenario, we can be resolute in maintaining that a supply-led fall in prices is good overall – not just for ‘consumers’ – but for intermediary producers of all other goods and services, too. And, yes, it may well be, as has been bandied about, that some 10% of US earnings are energy related and so in jeopardy, but devotees of Bastiat’s Things Which are Not Seen will have already asked themselves how much the earnings of energy users have been depressed by the success of the energy providers and whether, therefore, the ongoing rebalancing is the unmitigated evil some fear it to be.

Above all, we might take comfort from the realisation that oil & gas consumption still only amounts to 5% or so of global GDP. Or we could, were we not also to bring to mind the injunction that in a non-linear system such as ours we cannot entirely discount that large effects emanate from small causes or that, given its high profile, the sector’s travails could contribute meaningfully to a souring of general sentiment and so perhaps take us across that critical mass threshold beyond which rotations and reversals morph into landslides of liquidation. But to see why we think this is even possible, we need to go back a step or two to explain what we think is the source of such fragility.

Back in the immediate aftermath of LEH, we wrote that the scale of the coming reflation would be unprecedented and that it would certainly boost commodity and asset prices in the short run, but we also warned that we needed the debt overhang to be rapidly eradicated, renewed entrepreneurship to be promoted, and heavy-handed state intervention to be avoided (we entertained few real hopes on that that last score) if the recovery were to take root. Otherwise, we predicted, we would find ourselves on a tedious roller-coaster of anaemic growth interspersed with weary episodes of recurrent stagnation where the supposed triumph of the authorities’ 1933 moment would give way to their dread of repeating a 1937 one, meaning they could never pull the trigger on ending their stimulus programmes. This, we envisaged, would ensure that the whole system would become ever more addicted to the medicine and ever more subject to its unwelcome side-effects.

We also felt, back then, that if we were to avoid this switchback turning into a negative-g log flume of downturn, the West had to have its house in order by the time that China realised it was doing more harm than good with its own gargantuan injections and that it had to revise its whole approach as a consequence. So it is proving to be.

In the interim, we have all been strung along by the persistent faith that, this quarter, the next, or the one after that, Europe would once more arise from the ashes. When that seemed too much of a stretch we were briefly distracted instead with the foolishness that was Abenomics, and all the while we had the cheery presumption that the Daddy of them all, the US, was slowly getting back on track and so would be enough to keep our illusions alive.

But now we have nothing – or close thereto – to which to cling except for the fact that while so many central banks remain so doggedly accommodative we cannot seem to bring ourselves not to plunge for a further rise in the market. The pockets of our trousers have, after all, long since burned through as a result of all the hot money which has been thrust into them these past several years.

But, whatever the imperatives to remain fully invested and highly leveraged, it cannot be denied that the underpinnings of our optimism are becoming ever more slender. Japan has predictably disappointed. Europe again stands on the verge of major political upheaval and the reaction to the oft-promised QEuro has either been muted (in the real world) or actively counter-productive (in its disruptive, possibly system-threatening effect on the capital and currency markets), suggesting that clinical tolerance is setting in there, too.

EMs are over-owned, are becoming disfavoured, and are anyway not weighty enough to swing the balance. Add to this the sad fact that America is fostering conflict and instability all around the Eastern and Southern rim of Europe and we are left only with the belief in US economic recovery – at first stoutly resisted, but later held with all the fervour of the true convert – to maintain our faith. Hence, as we said, the outperformance of Wall St amid the growing strength of the dollar, a constellation which has even induced high-ranking pundits of the kind who should – but somehow never do – know better to start exulting recklessly at the putative ‘decoupling’ of the Land of the Free from the rest of the poor, huddled mass of humanity.

Now though, the States is starting to stutter as well – with a run of softer-than-expected macro data, fears of what the shale shock will mean both for jobs and credit, and a few wobbles on the corporate earnings front (even if many of these are only strong-dollar, money illusion effects).

In the recent past, such bad news would have been perversely seen as market positive for its capacity to call forth more from the Mighty Oz’s bag of monetary tricks. But what can we now expect from the ‘Goldilocks’ scenario of weakness calling forth some form of official, ‘Greenspan Put’ compensation? Only the weak, negative assistance that it might further delay the day the Fed finally takes its first baby steps to renormalization. There is therefore not much by way of porridge in that particular bowl, we fear!

In such a world, it would not take much for the multitude of stale longs to become anxious. Though it will be said – as it always is – that there is copious ‘cash on the sidelines’ waiting for exactly such an opportunity or, conversely, that a setback in one market must lead to a rise in another (‘the money has to go somewhere’), this overlooks the fact that asset prices can only advance on such a broad and enduring front as they have if they are being fed a steady nourishment of a credit created expressly for that purpose.

When this is the case, it is just as true in reverse; that when people take fright and the assets begin to fall, or the carry trade starts to go awry, the associated credit can quickly evaporate – that where the money ‘goes’ is whence it came: into fractional reserve oblivion. The one place where the classic Fisherian ‘debt deflation’ – or, if you prefer, the Hayekian ‘secondary depression’ – can most easily occur is in the market for financial claims, especially when that market may already have reached its ‘permanently high plateau’.

It may not happen just yet, but it certainly pays to be alert to the possibility that, one fine morning, it surely will.

Economics

“A more serious disaster later on..”

“Another day, another central bank failure. In a world of currencies backed only by confidence, every failure is masqueraded as success. Like the ballet dancer who transforms the stumble into a pirouette, central bankers, knocked to the ground by market forces, smile and pretend that this was all part of the routine. Financial market participants, having bet everything on the promised omnipotence of central bankers, do indeed seem happy to see genius in every stumble. However a fall is a fall regardless of the style of the descent. So when will investors see that the earth is rapidly approaching and that style is just style?

“..Taking interest rates so negative that they threaten a run on bank deposits should not be seen as success — it is failure. Creating bank reserves at that pace should not be seen as success — it is failure. The next failure may well be some government-inspired restriction on capital inflows. Well, you could call such restrictions, and risking the liquidity of banks, monetary success if you like, but then you probably also think it’s a success to throw the ball one yard from the touchline.”

–       Russell Napier, ‘The Solid Ground’, 5th February 2015.

 

“..The position of the people who had at least nominal responsibility for what was going on was a complex one. One of the oldest puzzles of politics is who is to regulate the regulators. But an equally baffling problem, which has never received the attention it deserves, is who is to make wise those who are required to have wisdom.

“Some of those in positions of authority wanted the boom to continue. They were making money out of it, and they may have had an intimation of the personal disaster which awaited them when the boom came to an end. But there were also some who saw, however dimly, that a wild speculation was in progress and that something should be done. For these people, however, every proposal to act raised the same intractable problem. The consequences of successful action seemed almost as terrible as the consequences of inaction, and they could be more horrible for those who took the action.

“A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who sensed what was happening in early 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. (For nearly a decade the Federal Reserve authorities had been denying their responsibility for the deflation of 1920-1.) The eventual disaster also had the inestimable advantage of allowing a few more days, weeks, or months of life. One may doubt if at any time in early 1929 the problem was ever framed in terms of quite such stark alternatives. But however disguised or evaded, these were the choices which haunted every serious conference on what to do about the market.”

–       J.K. Galbraith, ‘The Great Crash 1929’.

 

 

“It’s a mess, ain’t it, Sheriff ?”

“If it ain’t, it’ll do ‘til the mess gets here.”

–       Dialogue from ‘No country for old men’, by the Coen Brothers and Cormac McCarthy.

 

There are some time-honoured signs of an impending market top. One of them is thatmargin debt has peaked. Another is that interest rates are going through the floor. Another is that market breadth is contracting. Another is that the velocity of money is also going through the floor. Another is that Abby Joseph Cohen reckons the stock market is relatively cheap, an opinion which she generously gave at a recent Barrons roundtable. Barrons actually gave us two signs of a market top for the price of one (but then everything’s devalued these days) – their February 6th edition pointed out that the value of fine art sold at auction had quadrupled from $3.9 billion in 2004 to some $16.2 billion in 2014. They tastefully offered readers a choice between the conclusions of malign ‘bubble’ and benign ‘boom’.

The problem is that in an environment of ubiquitous government manipulation, markets can trade at whatever levels central bankers want them to trade at, for a period at least. So we’re not going to be rash enough to call a market top; we’ll merely draw attention to some anecdotal evidence of a certain, how shall we put it, irrational exuberance at work in the US stock market.

We tip our hat to Beijing Perspective and the Wall Street Journal for the recent news that Carmine “Tom” Biscardi is on the hunt for Bigfoot, and is planning an IPO to fund the expedition:

“Mr. Biscardi and his partners hope to raise as much as $3 million by selling stock in Bigfoot Project Investments. They plan to spend the money making movies and selling DVDs, but are also budgeting $113,805 a year for expeditions to find the beast. Among the company’s goals, according to its filings with the Securities and Exchange Commission: “capture the creature known as Bigfoot.”

“Investment advisers caution that this IPO may not be for everyone. For starters, it involves DVDs, a dying technology, said Kathy Boyle, president at Chapin Hill Advisors. Then there is the Sasquatch issue. She reckons only true believers would be interested in such a speculative venture.”

This is a wonderful instance of life imitating art. Note the similarities between the Bigfoot story (which we have to presume is true) and The Onion’s market scoop from November 1999 (the date is instructive), namely

Species of blue-green algae announces IPO

“LAKE ERIE—Seeking to capitalize on the recent IPO rage on Wall Street, Lake Erie-based blue-green algae Anabaena announced Tuesday that it will go public next week with its first-ever stock offering.

“Anabaena, a photosynthesizing, nitrogen-fixing algae with 1999 revenues estimated at $0 billion, will offer 200 million shares on the NASDAQ exchange next Wednesday under the stock symbol ALG. The shares are expected to open in the $47-$49 range.”

It gets better. With eerie genius:

“..Still, many investors said they are unsure whether they would be willing to take even a moderate risk on the stock.

“One thing they’re not saying in the prospectus—and I’ve been through it thoroughly—is that blue-green algae aren’t really algae. They’re cyanobacteria,” said Jeanette MacAlester, a San Francisco-based stockbroker who is strongly advising her clients not to buy ALG. “I don’t know if I’d put my money in any bacteria, let alone one that seems to think it has something to hide.”

Markets are allowed their petty indiscretions, of course. But these petty indiscretions seem to be piling up. Barry Ritholtz and Bloomberg last week drew attention to the fact that shares of The Grilled Cheese Truck Inc. had commenced trading on the OTCQX marketplace under the ticker GRLD:

“Let’s look at the fundamentals of the Ft. Lauderdale, Florida-based company. Based on the 18 million shares outstanding and a recent stock price of $6 the company has a market value of about $108 million. No matter how much you like grilled cheese.. I can’t see this as a reasonable valuation.

“If you go to the company’s website, you will learn that “The company currently operates and licenses grilled cheese food trucks in the Los Angeles, CA area and Phoenix, AZ and is expanding into additional markets with the goal of becoming the largest operator in thegourmet grilled cheese space.”  You can see an interview with the founder here. The company employs military veterans, and it even lists retired General Wesley Clark as vice chairman.

“However, according to the company’s financial statements, it has about $1 million of assets and almost $3 million in liabilities. In the third quarter of 2014, it had sales of almost $1 million, on which it had a net loss of more than  $900,000.  The story is much the same for the first nine months of the year: $2.6 million in sales and a loss of $4.4 million.

“But forget the losses for a moment, and make the generous assumption that it will have sales of $4 million this year. This means its shares trade for more than 25 times sales, a very rich valuation.

“Which brings me back to my original comments regarding looking for contrary indicators to my bullish posture. I can’t think of a more interesting sign of the old irrational exuberance in equity markets than a publicly traded grilled cheese truck (four in this case) business trading at a $100-million-plus valuation. That sort of thing doesn’t happen unless there is significant excess in the markets.”

Any reference to a company seeking to dominate the “gourmet grilled cheese space” is desperately seeking a twin reference to a post we recall from the dotcom deadpool website F******Company.com from circa late 1999:

“Our business strategy is to lose money on every sale but make up for it in volume.”

Enjoy the party, but dance near the door.

 

Economics

Does a fall in unemployment lead to stronger economic growth?

For the head of the Federal Reserve Board Janet Yellen and most economists the key to economic growth is a strengthening in the labor market. The strength of the labor market is the key behind the strength of the economy – so it is held. If this is the case then it is valid to conclude that changes in unemployment are an important causative factor of real economic growth.

This way of thinking is based on the view that a reduction in the number of unemployed means that more people can now afford to boost their expenditure. As a result, economic growth follows suit, it is held.

We suggest that the main driver of economic growth is an expanding pool of real wealth. Fixing unemployment without addressing the issue of wealth is not going to lift the economic growth as such.

It is the pool of real wealth that funds the enhancement and the expansion of the infrastructure. An enhanced and expanded infrastructure permits an expansion in the production of the final goods and services required to maintain and promote individuals’ lives and well being.

If unemployment were the key driving force of economic growth then it would have made a lot of sense to eradicate unemployment as soon as possible by generating all sorts of employment.

For instance, policy makers could follow the advice of Keynes and his followers and employ people in digging ditches, or various other government sponsored activities. Note that the aim here is just to employ as many people as possible.

A simple commonsense analysis however quickly establishes that such a policy would amount to depletion in the pool of real wealth. Remember that every activity whether productive or non-productive must be funded.

Hence employing individuals in various useless non-wealth generating activities simply leads to a transfer of real wealth from wealth generating activities and this undermines the real wealth generating process.

Unemployment as such can be relatively easily fixed if the labor market were to be free of tampering by the government. In an unhampered labor market any individual that wants to work will be able to find a job at a going wage for his particular skills.

Obviously if an individual demands a non-market related salary and is not prepared to move to other locations there is no guarantee that he will find a job.

For instance, if a market wage for John the baker is $80,000 per year yet he insists on a salary of $500,000, obviously he is likely to be unemployed.

Over time a free labor market makes sure that every individual earns in accordance to his contribution to the so-called overall “real pie”. Any deviation from the value of his true contribution sets in motion corrective competitive forces.

Ultimately what matters for the well-being of individuals is not that they are employed as such, but their purchasing power in terms of the goods and services that they earn.

It is not going to be of much help to individuals if what they are earning will not allow them to support their life and well being.

Individuals’ purchasing power is conditioned upon the infrastructure that they operate. The better the infrastructure the more output an individual can generate.

A higher output means that a worker can now command higher wages in terms of purchasing power.

Economics

Sovereign Bonds

Today’s obvious mispricing of sovereign bonds is a bonanza for spending politicians and allows over-leveraged banks to build up their capital. This mispricing has gone so far that negative interest rates have become common: in Denmark, where the central bank persists in holding the krona peg to a weakening euro, it is reported that even some mortgage rates have gone negative, and high quality corporate bonds such as a recent Nestlé euro bond issue are also flirting with negative yields.

The most identifiable reason for this distortion of free markets is bank regulation. Under the Basel 3 rules, a bank with sovereign debt on its balance sheet is regarded by bank regulators as owning a risk-free asset.

Unsurprisingly, banks are encouraged by this to invest in sovereign debt in preference to anything else. This leads to the self-fulfilling second reason: falling yields. Central bank intervention in the bond markets through quantitative easing and commercial bank buying leads to higher bond prices, which in turn give the banks enormous profits. It is a process that the banks wish would go on for ever, but logic says it doesn’t.

Don’t think that there is an economic justification for negative bond yields: there isn’t. Even if price inflation goes negative, interest rates in a free market will always remain positive. The reason for this cast-iron rule is interest rates are an expression of time-preference. Time preference is the solid reason that possession of money today is more valuable than a promise to give it to you at some time in the future. The future value of money must always be at a discount to cash-in-the-hand, or put the other way, to balance the value of cash today with cash tomorrow always requires a supplementary payment of interest. That is always true so long as interest rates are set by genuine market factors and not set by a market-monopolising central bank, and then distorted by banking regulations.

So we have arrived close to the logical end-point in falling yields, and in some cases we have gone beyond it. We must also conclude that negative yields are a signal that bond prices are so over-blown that they are vulnerable to a substantial correction. Furthermore, when the tide turns against bond markets the downside could be considerable. The long-term real yield on high quality government bonds has historically tended to average about three per cent, which implies that sovereign bonds would crash if central banks lost control of the market.

Bond bulls are on weak ground from another angle. If history tells us that real yields of three per cent are the norm, has government creditworthiness changed for the better, justifying a lower yield? Well, no: the accumulation of debt across all welfare economies is less sustainable than at any time in the past, and demographics, the number of retirees relative to those in work and paying taxes, are rapidly making the situation far worse.

Macroeconomists will probably claim that so long as central banks can continue to manage the quantity of money sloshing about in financial markets they can keep bond prices up. But this is valid only so long as markets believe this to be true. Put another way central banks have to continue fooling all of the people all of the time, which as we all know is impossible.

Economics

The Swiss Franc Will Collapse

I have worked to keep this piece readable, and as brief as possible. My grave diagnosis demands the evidence and reasoning to support it. One cannot explain the collapse of this currency with the conventional view. “They will print money to infinity,” may be popular but it’s not accurate. The coming destruction has nothing to do with the quantity of money. It is a story of what happens when interest rates fall into a black hole.

 

Yields Have Fallen Beyond Zero

The Swiss yield curve looks like nothing so much as a sinking ship. All but the 20- and 30-year bonds are now below the water line.

Swiss Interest Rates

 

Look at how much it’s submerged in just one week. The top line (yellow) is January 16, and the one below it was taken just a week later on January 23. It’s terrifying how fast the whole interest rate structure sank. Here is a graph of the 10-year bond since September. For comparison, the 10-year Treasury bond would not fit on this chart. The US bond currently pays 1.8%.

Swiss 10 year bond

 

The Swiss 10-year yield was as high as 37 basis points on Friday January 2. By the next Monday, it had plunged to 28, or -25%. By January 15—the day the Swiss National Bank (SNB) announced it was removing the peg to the euro—the yield had plunged to just 7 basis points. It has been nonstop freefall since then, currently to -26 basis points.

What can explain this epic collapse? Why is the entire Swiss bond market drowning?

Drowning is a fitting metaphor. In my dissertation, I describe several harbingers of financial and monetary collapse. The first is when the interest interest rate on the long bond goes to zero. I discuss the fact that a falling rate destroys capital, and that lower rates mean a higher burden of debt. If the long bond rate is zero then the net present value of all debt (which is effectively perpetual) is infinite. Debtors cannot carry an infinite burden. As we’ll see, any monetary system that depends on debtors servicing their debt must collapse when the rate goes to zero.

I think the franc has reached the end. With negative rates out to 15 years, and a scant 33 basis points on the 30-year, it is all over but the shouting.

Not Printing, Borrowing

Let’s take a step back for a moment, and look at how the recent chapter unfolded. It began with the SNB borrowing mass quantities of francs. Most people say printed, but it’s impossible to understand this unprecedented disaster with such an approximate understanding. It’s not printing, but borrowing.

Think of a homebuyer borrowing $100,000 to buy a house. He never gets the cash in his bank account. He signs a bunch of paperwork, and then at the end of the day he has a debt obligation to repay, plus the title to the house. The former owner has the cash.

It works the same with any central bank that wants to buy an asset. At the end of the day, the bank owns the asset, and the former owner of the asset now holds the cash. This cash is the debt of the central bank. It is on the bank’s balance sheet as a liability. The bank owes it.

This is vitally important to understand, and it can be quite counterintuitive. If one thinks of the franc (or dollar, euro, etc.) as money, and if one thinks that the central banks print money, then one will come to precisely the wrong conclusion: that there is nothing owed, and indeed there is no debtor. In this view, the holder of francs has cash, which is a current asset. End of story.

This conclusion could not be more wrong.

Certainly, the idea of the central bank repaying its debt is absurd. By law, payment is deemed made when the debtor pays in currency—i.e. francs in Switzerland. However, the franc is the very liability of the SNB that we’re discussing. How can the SNB pay off its franc liabilities using its own franc liabilities as means of payment?

It can’t. This is a contradiction in terms. Thus it’s critical to understand that there is no extinguisher of debt in the regime of irredeemable paper currency. You may get yourself out of the debt loop by paying in currency, but that merely shifts the debt. The debt does not go out of existence, because paying a debt with an IOU cannot extinguish it. Unlike you, the central bank cannot get itself out of debt.

However, it can service its debt. For example, the Federal Reserve in the U.S. pays interest on reserves. Indeed, the bank must service its debts. It would be a calamity if a payment is missed, if the central bank ever defaulted.

The central bank must also maintain its liabilities, which is what it uses to fund its assets. If the commercial banks withdraw their deposits—and they do generally have a choice—the central bank would be forced to sell its assets. That would be contrary to its policy intent, not to mention quite a shock to brittle economies.

Make no mistake, a central bank can go bankrupt. This may seem tricky to understand, as the law makes its liability legal tender for all debts public and private. A central bank is also allowed to commit acts of accounting (and leverage) that would not be tolerated in a private company. Regardless, it can present misleading financial statements, but even if the law lets it get away with that, reality will have its revenge in the end. The emperor may claim to be wearing magnificent royal robes, but he’s still naked.

If liabilities exceed assets, then a bank—even a central bank—is insolvent and the consequences will come soon enough. The cash flow from the assets will sooner or later become insufficient to pay the interest on the liabilities. No central bank wants to be in a position where it is obliged to borrow, not to purchase asset but to service a negative cash flow. That is a rapid death spiral. It must somehow push down the interest rate on its liabilities (which are typically short term) to keep the cost of financing its portfolio below the revenue generated on the assets.

This becomes increasingly tricky when two things happen. One, the yield on the asset goes negative. Thus, the even-more-negative (and even more absurd) one-day rate of -400 basis points in Switzerland. Two, the issuance of more currency drives down yields even further (described in detail, below).

Events force the hand of the central bank. It goes down a path where it has fewer and fewer choices. That brings us back to negative interest rates out to the 15-year bond so far.

The Visible Hand of the Swiss National Bank

So the SNB issued francs to fund its purchase of euros. Next, it spent the euros on whatever Eurozone assets it wished to buy, such as German bunds.

It’s well known that the SNB put on a lot of this trade to keep the franc down to €0.83 (the inverse of keeping the euro down to CHF1.2) l. It also helped push down interest rates in Europe. The SNB was a relentless buyer of European bonds.

That leads to the question of what it did in Switzerland. The SNB was trading new francs for euros. That means the former owner of those euros then owned francs. These francs have to stay in the franc-denominated domain. What asset will this new franc owner buy?

I frame the question this way deliberately. If you have a 100-franc note, you can put it in your pocket. If you have CHF100,000, you can deposit it in a bank. If you have CHF100,000,000 (or billions) then you are going to buy a bond or other asset (depositing cash in a bank just pushes it to the bank, who buys the asset).

The seller of the asset is selling on an uptick. He gives up the bond, because at its higher price (and hence lower yield) he now finds another asset more attractive on a risk-adjusted basis. Risk includes his own liquidity risk (which of course rises as his leverage increases).

As the SNB (and many others) relentlessly push up the bond price, and hence push down the yield, the sellers of the ever-lower yielding bonds have fresh new franc cash balances.

The Quantity Theory of Money holds that the demand for money falls as the quantity rises. If demand for money falls, then by this definition the prices of all other things—including consumer goods—rises. It is commonly held that people tradeoff between saving money vs. spending money (i.e. consumption). The prediction is rising consumer prices.

I emphatically disagree. A wealthy investor does unload his assets to go on an extra vacation if he doesn’t like the bond yield. A bank with a trillion dollar balance sheet does not dole out bigger salaries if its margins are compressed.

So what does trade off with government bonds? If an investor doesn’t want to own a government bond, what else might he want to own? He buys corporate bonds, stocks, or rental real estate, thus pushing up their prices and yields down.

And then, in a dysfunctional monetary system, you can add antique cars, paintings, a second and third home, etc. These things serve as surrogates for investment. When investing cannot produce an adequate yield, people turn to non-yielding non-investment assets.

The addition of a new franc at the margin perturbs the previous equilibrium of risk-adjusted yields across all asset classes. Every time the bond price goes up, every owner of every franc-denominated asset must recalculate his preferences.

The problem is that the SNB does not create any more productive investment opportunities when it spills more francs into the Swiss financial system. Those new francs have to chase after the existing assets.

Yields are falling. They necessarily had to fall.

An Increasing Money Supply and Decreasing Interest Rate

The above discussion describes the picture in every developed economy. Interest rates have been falling for 34 years in the U.S., for example.

In a free market, the expansion of credit would be driven by a market spread: available yield – cost of borrowing. If that spread is too small (or negative) there will be no more borrowing to buy assets. If it gets wider, then banks can spring into action.

However, central banks distort this. Instead of the cost of borrowing being a market-determined price, it is fixed by the central bank. This perverts the business model of a bank into what is euphemistically known as maturity transformation—borrowing short to lend long. It’s not possible for a bank to borrow money from depositors with 5-year time deposit accounts in order to buy 5-year bonds. The bank has to borrow a shorter duration and buy a longer, in order to make a reasonable profit margin.

If the central bank sets the borrowing cost lower and lower, then the banks can bid up the price of government bonds higher and higher (which causes a lower and lower yield on the long bond). This is not capitalism at all, but a centrally planned kabuki theater. All of the rules are set by a non-market actor, who can change them for political expediency.

The net result is issuance of credit far beyond what could ever happen in a free market. This problem is compounded by the fact that the central bank cannot control what assets get bought when it buys bonds. It hands the cash over to the former bond holders. It’s trying to accomplish something—such as keeping the franc down in the case of the SNB, or preventing bankruptcies, in the case of the Fed—and it has no choice but to keep flooding the market until it achieves its goal. In the US, the rising tide eventually lifted all ships, even the leaky old tubs. The result is a steeper credit gradient, and the bank can eventually force liquidity out to its target debtors.

The situation in Switzerland makes the Fed’s problems look small by comparison. Unlike the Fed, which had a relatively well-defined goal, the SNB put itself at the mercy of the currency market. It had no particular goal, and therefore no particular budget or cost. The SNB was fighting to hold a line against the world. While it kept the franc peg, the SNB put pressure on both Swiss and European interest rates.

Something changed with the start of the year. We can understand it in light of the arbitrage between the Swiss bond, and other Swiss assets. The risk-adjusted rate of return on other assets always has to be greater than that of the Swiss government bond (except perhaps at the peak of a bubble). Otherwise why would anyone own the higher-risk and lower-yield asset?

Therefore, there are three possible causes for the utter collapse in interest rates in Switzerland beginning 10 days prior to the abandonment of the peg:

  1. the rate of return of other assets has been leading the drop in yields
  2. buying pressure on the franc obliged the SNB to borrow more francs into existence, fueling more bond buying
  3. the risk of other assets has been rising (including liquidity risk to their leveraged owners)

#1 is doubtful. It’s surely the other way around. It’s not falling yields on real estate driving falling yields on bonds. Bond holders are induced to part with their bonds on a SNB-subsidized uptick. Then they use the proceeds to buy something else, and drive its yield down.

One fact supports conclusion #2. Something forced the SNB to remove the peg. Buying pressure is the only thing that makes any sense. The SNB hit its stop-loss.

The rate of interest continued to fall even after the SNB abandoned its peg. Why? Reason #3, rising risks. Think of a bank which borrowed in Swiss francs to buy Eurozone assets. This trade seemed safe with the franc pegged to the euro. When the peg was lifted, suddenly the firm was faced with a staggering loss incurred in a very short time.

The overreaction of the franc in the minutes following the SNB’s policy change had to be the urgent closing of Eurozone positions by many of these players. The franc went from €0.83 to €1.15 in 10 minutes, before settling down near €0.96. For those balance sheets denominated in francs, this looked like the euro moved from CHF1.20 to CHF0.87, a loss of 28%. What would you do, if your positions instantly lost so much? Most people would try to close their positions.

Closing means selling Eurozone assets to get francs. Then you need to buy a franc-denominated asset, such as the Swiss government bond. That clearly happened big-time, as we see in the incredible drop in the interest rate in Switzerland. Francs which had formerly been used to fund Eurozone assets must now be used to fund assets exclusively in the much-smaller Swiss realm.

In other words, a great deal of franc credit was used to finance Eurozone assets. This is a big world, and hence the franc carry trade didn’t dominate it. When those francs had to go home and finance Swiss assets only, it capsized the market.

And the entire yield curve is now sinking into a sea of negative rates.

The Consequences of Falling Interest

Meanwhile, unnaturally low interest is offering perverse incentives to corporations who can issue franc-denominated liabilities. They are being forced-fed with credit, like ducks being fatted for foie gras. This surely must be fueling all manner of malinvestment, including overbuilding of unnecessary capacity. The hurdle to build a business case has never been lower, because the cost of borrowing has never been lower. The consequence is to push down the rate of profit, as competitors expand production to chase smaller returns. All thanks to ever-cheaper credit.

Artificially low interest in Switzerland is causing rising risk and, at the same time, falling returns.

The Swiss situation is truly amazing. One has to go out to 20 years to see a positive number for yield—if one can call 21 basis points much of a yield.

It’s not only pathological, but terminal. This is the end.

In Switzerland, there is hardly any incentive remaining to do the right things, such as save and invest for the long term. However, there’s no lack of perverse incentives to borrow more and speculate on asset prices detaching even further from reality.

Speculation is in its own class of perversity. Speculation is a process that converts one man’s capital into another man’s income. The owner of capital, as I noted earlier, does not want to squander it. The recipient of income, on the other hand, is happy to spend some of it.

We should think of a falling interest rate (i.e. rising bond market and hence rising asset markets) as sucking the juice (capital) out of the system. While the juice is flowing, asset owners can spend, and lots of people are employed (especially in the service sector).

For example, picture a homeowner in a housing bubble. Every year, the market price of his house is up 20%. Many homeowners might consider borrowing money against their houses. They spend this money freely. Suppose a house goes up in price from $100,000 to $1,000,000 in a little over a decade. Unfortunately, the debt owed on the house goes up proportionally.

With financial assets, they typically change hands many times on the way up. In each case, the sellers may spend some of their gains. Certainly, the brokers, advisors, custodians, and other professionals all get a cut—and the tax man too. At the end of the day, you have higher prices but not higher equity. In other words, the capital ratio in the market collapses.

To understand the devastating significance of this, consider two business owners. Both have small print shops. Both have $1,000,000 worth of presses, cutters, binding machines, etc. One owns everything outright; he paid cash when he bought it. The other used every penny of financing he could get, and has a monthly payment of about $18,000. Both shops have the same cost of doing business, say $6,000. If sales revenues are $27,000 then both owners may feel they are doing well. What happens if revenues drop by $3,500? The all-equity owner is fine. He can reduce the dividend a bit. The leveraged owner is forced to default. The more your leverage, the more vulnerable you are to a drop in revenues or asset values.

Falling interest, and its attendant rising asset prices, juices up the economy. People feel richer (especially if their estimation of their wealth is portfolio value divided by consumer prices) and spend freely. Unfortunately, it becomes harder and harder to extract smaller and smaller drops of juice. The marginal productivity of debt falls.

Think about it from the other side, the borrower. The very capacity to pay interest has been falling for decades. A declining rate of profit goes hand-in-hand with a falling rate of interest. Lower profit is both caused by lower interest, and also the cause of it. A business with less profit is less able to pay interest expense. Who could afford to pay rates that were considered to be normal just a few decades ago? It is capital that makes profit, and hence capacity to pay interest, possible. And it is capital that’s eroded by falling rates.

The stream of endless bubbles is just the flip side of the endless consumption of capital. Except, there is an end. There is no way of avoiding it now, for Switzerland.

How About Just Shrinking the Money Supply?

Monetarists often tell us that the central bank can shrink the money supply as well as grow it, and the reason why it’s never happened is, well… the wrong people were in charge.

I disagree.

To see why, let’s look at the mechanism for how a central bank expands the money supply. It issues cash to an asset owner, and the asset changes hands. Now the bank owns the asset and the seller owns the cash (which he will promptly use to buy the next best asset). A relentlessly rising bond price is lots of fun. It’s called a bull market, and everyone is making profits as they reckon them (actually consuming capital, as we said above).

How would a contraction of the money supply work? It seems simple, at first. The central bank just sells an asset and gets back the cash. The cash is actually its own liability, so it can just retire it. And voila. The money supply shrinks.

Not so fast.

There is an old saying among traders. Markets take the escalator up, but the elevator down. Central bank buying slowly but relentlessly bid up the price of bonds. Tick by tick, the bank forced it up. What would central bank selling do? What would even a rumor of massive central bank selling do?

Bond prices would fall sharply.

The problem is that few can tolerate falling bond prices, because everyone is leveraged. Think about what it means for everyone to borrow and buy assets, for sellers to consume some profits and reinvest the proceeds into other assets. There is increasingly scant capital base supporting an increasingly inflated—as in puffed-up with air, without much substance—asset market. A small decline in prices across all asset classes would wipe out the financial system.

Market participants have to be leveraged. Dirt cheap credit not only makes leverage possible, but also necessary. How else to keep the doors open, without using leverage? Spreads are too thin to support anyone, unlevered.

Banks are also maturity mismatched, borrowing short to lend long. The consequences of a rate hike will be devastating, crushing banks on both sides of the balance sheet. On the liabilities side, the cost of funding rises with each uptick in the interest rate. On the asset side, long bonds fall in value at the same time. If short-term rates rise enough, banks will have a negative cash flow.

For example, imagine owning a 10-year bond that pays 250 basis points. To finance it, you borrow at 25 basis points. Well, now imagine your financing cost rises to 400 basis points. For every dollar worth of bonds you own, you lose 1.5 cents per year. This problem can also afflict the central bank itself.

You have a cash flow problem. You are also bust.

The Bottom Line

The problem of falling rates is crushing everyone, but raising the rate cannot fix the problem. It should not be surprising that, after decades of capital destruction—caused by falling rates—the ruins of a once-great accumulation of wealth cannot be repaired by raising the interest rate.

I do not see any way out for the Swiss National Bank and the franc, within the system of irredeemable paper money. However, unless the SNB can get out of this jam, the franc is doomed. I can’t predict the timing, but I believe the fuse is lit and the powder keg could go off at any time.

One day, a bankruptcy will happen. Soothing voices will assure us it was unexpected. Then another will happen, perhaps triggered by the first or perhaps not. Then the cascading begins. One party’s liabilities are another’s assets. ABC’s bankruptcy wipes out DEF’s asset. Since DEF is leveraged, it cannot absorb much loss until it, too, is dragged under.

Somewhere in the midst of this, people will turn against the franc. Today, it’s arguably the most loved paper currency. However, I don’t think it will take too many capital losses in Switzerland, before there is a selling stampede. The currency will fall to zero, in a repeat of a pattern that the world has seen many times before.

People will call it hyperinflation (I don’t prefer that term). Call it what you will, it will be the death of the franc. It will have nothing to do with the quantity of money.

Two factors can delay the inevitable. One, the SNB may unwind its euro position. As this will involve selling euros to buy francs, the result will be to put a firm bid under the franc. Two, speculators will of course know this is happening and eagerly front-run the SNB. After all, the SNB is not an arbitrager buying when it can make a spread. It is a buyer by mandate (in this scenario) and must pay the ask price. Even if the SNB does not unwind, speculators may buy the franc and wait for it to happen. And of course, they could also buy based on a poor understanding of what’s happening, or due to other perverse incentives in their own countries.

Bankruptcies aside, the franc is already set on a hair-trigger. Something else could trip it and begin the process of collapse. There is little reason for holding Swiss francs in preference to dollars. The interest rate differential is huge. The 10-year US Treasury pays 1.8%. Compare that to the Swiss bond which charges you 26 basis points, and the difference is over 208 points in favor of the US Treasury. Once the risk of a rising franc is taken out of the market (by time or price action) this trade will commence. A falling franc against the dollar will add further kick to this trade. A trickle could become a torrent very quickly.

I would not be surprised if the process of collapse of the franc began next week, nor if it lingered all year. This kind of event is not susceptible to a precise prediction of when.

What is clear is that, once the process begins in earnest, it will be explosive, highly non-linear, and over quickly (I would guess a matter weeks).

 

Economics

Asset managers or asset gatherers?

“The Bank of England paid nearly £3m of taxpayers’ money for a report on whether any of its staff knew about or were involved in illegal manipulation of one of the world’s biggest financial markets.”

– Caroline Binham of The Financial Times, covering allegations of foreign exchange market rigging, and showing how the Bank of England is clearly on top of things, 31st January 2015.

 

“There are myths and pseudo-science all over the place. I might be quite wrong, maybe they do know all this … but I don’t think I’m wrong, you see I have the advantage of having found out how difficult it is to really know something. How careful you have to be about checking the experiments, how easy it is to make mistakes and fool yourself. I know what it means to know something. And therefore, I see how they get their information and I can’t believe that they know it. They haven’t done the work necessary, they haven’t done the checks necessary, they haven’t taken the care necessary. I have a great suspicion that they don’t know and that they’re intimidating people.”

– Richard Feynman on ‘experts’.

 

“Sir, Martin Wolf (“Draghi’s bold promise to do what it takes for as long as it takes”) is right to dismiss many of the arguments against QE. But, while QE will not necessarily cause hyperinflation, there is a real risk.

“Central banks have to date simultaneously “printed money” in massive amounts in QE programmes but have then used different mechanisms to “sterilise” the money so that it doesn’t go out in the economy.

“There have been massive increases in reserves held by banks. I have described this as driving with one foot on the throttle and the other on the brake. This means that the money printing hasn’t been inflationary, but it also means that QE has a small bang per buck, working through asset prices rather than real investment. It hasn’t done much for the real economy but has increased stock market prices and the wealth of the 1 per cent.

“The unwinding of the policy needed in the medium term, to avoid hyperinflation, is to sell the assets bought in QE back to the market. So, at some date in the future, bold central banks will need to engineer negative effects more or less equal to the positive effects today. In fact, they will be selling back to the market at a time when interest rates are higher and bond prices lower, taking a loss on the sale.

“The worry is that central banks will find it easier to just let the money flow into the economy at the worst possible time, once the economy has recovered and banks want to lend the money out. The sums are huge, and would then lead to very high inflation.

“The problem with QE is that it’s the wrong monetary policy. It isn’t bold to print money. It will be bold to withdraw it later.”

– Letter to the Financial Times from Mr Jeff Frank, Professor of Economics, Royal Holloway, University of London, UK, 27th January 2015.

 

Ever heard of Edward G. Leffler ? No, we hadn’t either. But in the words of author and Wall Street Journal columnist Jason Zweig, Leffler was

“the most important person in mutual fund history”.

The financial services industry is not exactly awash with innovations delivering tangible social value. The former Federal Reserve chairman Paul Volcker once suggested that the only useful banking innovation was the ATM machine. Leffler’s claim to fame ? He invented the open-ended fund.

Leffler originally sold pots and pans. But he was not slow to appreciate that selling investments might be more lucrative. In March 1924 he helped launch Massachusetts Investors Trust, the first open-ended fund. Its charter stipulated that “investors could present their shares and receive liquidating values at any time.”

Its impact was similar to that of Henry Ford’s development of the assembly line. It turned asset management into an industrial process. Whereas closed-ended funds contained a fixed amount of capital, open-ended funds had the potential for unlimited growth. As Zweig fairly observes, like any human innovation, the open-ended fund could be used for good, or ill.

He cites Alfred Jaretski, the securities lawyer who helped to draft the Investment Company Act:

“As there is normally a constant liquidation by shareholders who for one reason or another desire to cash in on their shares, the open-end companies must engage in continuous selling of new shares of stock in order to replace the shares so withdrawn…. Under these circumstances, and with keen competition between companies in the sale of their shares, it [is] natural that some questionable practices should [develop]. It furthermore bec[o]me[s] extremely difficult, and in some instances impossible, for any one company or small group of companies to raise standards and at the same time compete with the others.”

At a stroke, the invention of the open-ended fund created a schism in the asset management industry. Institutional investors would thereafter have to make a choice. They could be asset managers, or they could be asset gatherers. But they could not be both. Zweig describes the split as one between an investment firm and a marketing firm. The difference ?

“The marketing firm has a mad scientists’ lab to “incubate” new funds and kill them if they don’t work. The investment firm does not.

The marketing firm charges a flat management fee, no matter how large its funds grow, and it keeps its expenses unacceptably high. The investment firm does not.

The marketing firm refuses to close its funds to new investors no matter how large and unwieldy they get. The investment firm does not.

The marketing firm hypes the track records of its tiniest funds, even though it knows their returns will shrink as the funds grow. The investment firm does not.

The marketing firm creates new funds because they will sell, rather than because they are good investments. The investment firm does not.

The marketing firm promotes its bond funds on their yield, it flashes “NUMBER ONE” for some time period in all its stock fund ads, and it uses mountain charts as steep as the Alps in all its promotional material. The investment firm does none of those things.

The marketing firm pays its portfolio managers on the basis not just of their investment performance but also the assets and cash flow of the funds. The investment firm does not.

The marketing firm is eager for its existing customers to pay any price, and bear any burden, so that an infinite number of new customers can be rounded up through the so-called mutual fund supermarkets. The investment firm sets limits.

The marketing firm does little or nothing to warn its clients that markets do not always go up, that past performance is almost meaningless, and that the markets are riskiest precisely when they seem to be the safest. The investment firm tells its customers these things over and over and over again.

The marketing firm simply wants to git while the gittin’ is good. The investment firm asks, “What would happen to every aspect of our operations if the markets fell by 67% tomorrow, and what would we do about it? What plans do we need in place to survive it?””

So ultimately all fund managers must make a choice. As Zweig puts it,

“You can be mostly a marketing firm, or you can be mostly an investment firm. But you cannot serve both masters at the same time. Whatever you give to the one priority, you must take away from the other.

“The fund industry is a fiduciary business; I recognize that that’s a two-part term. Yes, you are fiduciaries; and yes, you also are businesses that seek to make and maximize profits. And that’s as it should be. In the long run, however, you cannot survive as a business unless you are a fiduciary emphatically first.

“In the short term, it pays off to be primarily a marketing firm, not an investment firm. But in the long term, that’s no way to build a great business. Today, tomorrow, and forever, the right question to ask yourselves is not “Will this sell?” but rather “Should we be selling this?” I will praise every fund company that makes that choice based on what is right for its investors, because I believe that standard of judgment is the right standard.”

There’s a fairly easy way to tell if a firm is a marketing firm or an investment firm. Do you see its advertising on buses, cabs and posters ? Do they have a practically limitless range of funds ? This is not to denigrate marketing firms entirely. But as the financial markets lurch between unprecedented bouts of bad policy, and achieve valuations that we strongly suspect are unlikely to persist, it may be worthwhile to consider the motives of the people charged with managing your money. Are they asset managers, or asset gatherers ? The answer may have some relevance for the sanctity and stability of your portfolio. And for your peace of mind.

Economics

Technical Update

Wracked by the actions of the various central banks – which gave us another key reminder that volatility does not equate to risk – yet not wishing to start rethinking their entire thesis, a characteristic loss confidence has started to set in among those who were telling themselves over the Christmas trukey just what geniuses they were. We could have an interesting couple of weeks in store – not helped by the fact that we are about to enter the great Chinese data avoid as the lunar new year approaches.

In China, the poorest industrial profit and revenue results in years, the slowest growth in the money supply, and the not unrelated presure on the yuan – where CNY6.27 looks increasingly important –  are still none of this is enough to halt the flood of hot money into equities.

15-01-28 China PftThe main boards may have temporarily found a ceiling but the Nasdaq/Neumarkt equivalent, ChiNext, has just threatened to resume the upmove. Sentimentals, remember, can always trump fundamentals. Or, as Frederick Lewis Allen put it a l-o-n-g time ago: ‘Hope can be exchanged for cash on a speculative market.’

Courtesy of Bloomberg
Courtesy of Bloomberg
Courtesy of Bloomberg
Courtesy of Bloomberg

As for other stock markets, it appears that something of a tug-of-war has developed. Just enough bad news to keep the bulls from becoming too enthusiastic, but not enough gloom to cede dominance to the bears. Another one of those situations where you have to wait to see who takes control before throwing your weight behind the move. Eg, MSCI World ex-USA:-

Courtesy of Bloomberg
Courtesy of Bloomberg

And the USA itself. Still some upside if this broad brush picture is going to deliver some wonderfully symmetric culminating action. But…..

Courtesy of Bloomberg
Courtesy of Bloomberg

…buyer beware: the ‘one-off’ shocks are starting to add up and the resulting rise in uncertainty can be seen in the usual places – vols, junk and EM spreads, the gold/industrial ratio and, arguably, the safe haven dollar trade (or, if you prefer, the end of carry).

Courtesy of Bloomberg
Courtesy of Bloomberg

Look, too, at how swings in yield differentials between the bellies of the US and German curves tend to signal turning points in the economic cycle.

Courtesy of Bloomberg
Courtesy of Bloomberg

The T-Bond, too, is pausing for breath after making a minor new historic yield low. While below 2.45/50%, the post-87 profile suggests a bottom at 2.25% (as we have already pointed out), but if things get really hairy, we might have to widen the range and plump for 1.50% for the Bond and 1.10% for the T-Note. RIP all bond vigilantes – a short memorial service will take place, followed by a reading from Homer & Sylla.

Courtesy of Bloomberg
Courtesy of Bloomberg

There is also a possible, very neat confluence of time and price coming together for USDDEM/EUR – a pairing which seems to oscillate on a cycle of roughly 15 years – 1970, 1985, 2000, and 2015 (?) marking the peaks for the dollar/troughs for the mark. $1.065/00 suggests itself as an objective. If we have to go beyond that, $0.9250/00 marks the log middle

Courtesy of Bloomberg
Courtesy of Bloomberg

As for commodities, the plain gold-in-dollar 2-year profile mapped out since 2013’s collapse looks balanced and, hence, potentially ready for a new trend move away from the mid-mean levels either side of $1300. Behaviour is somewhat harder to read of late for, since the turn of the year, the dynamic has not so much been dollar up, gold down (and v.v.) but euro weakness = gold strength. Such a confusion of signals – and hence of the underlying reasoning – is what we might expect at a turning point but do note that there is now a whole lot of positioning already in place betting on a further rise.

Courtesy of Bloomberg
Courtesy of Bloomberg

 

Courtesy of Bloomberg
Courtesy of Bloomberg

Industrial metals are again staring into the abyss,  as are iron ore, rebar, and coking coal on Shanghai.

Courtesy of Bloomberg
Courtesy of Bloomberg

Ags, too, are threatening support once more. Not only have harvests been good, but the collapse in crude is neutralising the single most important factor in the sector’s repricing these past ten years – biofuel. Ethanol is at 10-year lows, soy and palm oil are at levels not seen since 2009, sugar was first here all of four decades back and cheap petchems are forcing cotton and rubber lower, too.

Courtesy of Bloomberg
Courtesy of Bloomberg

Finally, oil itself. We have had almost three weeks of relative calm – itself a newsworthy event given what went on prior to that. But nothing seems able to actually reverse the trend, rather than simply suspend it. Specs are still heavily long, cracks are back to normal, production continues to defy the rig count, inventories are bulging, RSIs are now neutral – and all the while, value is building, not rejecting, right down here at the extremes.

Even allowing for the fact that the dollars you hand over for oil are themselves worth more these days, it is hard to resist the feeling that we will probe lower still before we are done. And some where down there lurks the 1974-2004 mean….

Courtesy of Bloomberg
Courtesy of Bloomberg linear scale
Courtesy of Bloomberg
Courtesy of Bloomberg log scale

Economics

Puppets pushing on a string

“I don’t think there is a problem that this will fix. I think it will just continue to compress yields into negative territory. If that’s the objective it will achieve it. The question is: will we regain European growth momentum and will labour markets pick up in particular outside Germany if we have a programme that buys debt including German sovereign debt ? So the bigger issue is for me a comparison with the US programme. The US QE programme was effective because a large part of the surge of US unemployment towards 10% was cyclical and the Fed provided a federal instrument – there is no risk-sharing because it was federal debt – and intervened in the most liquid market from which everything is priced.

“In Europe we don’t have such a bond market for, say, Eurobonds because the instrument doesn’t exist. It would be a risk-sharing instrument. Europe is not at that stage of political and fiscal integration. So whatever the ECB does they will not have a big impact on unemployment because most of European unemployment, unlike in the US, is not cyclical. European unemployment is high because of structural reasons. It is high because of inflexible labour market and product market structures, of pension systems, of medi-care systems, of a huge amount of government expenditure related to an ageing population. And so the better issue for Europe is to say: ‘we can help buy time as a central bank – governments should do the right thing’. And we’re seeing too little action too late from governments; in my view we’re seeing too much action too much upfront by the central bank and I think they should really work very hard for governments to face their responsibilities rather than taking on ever larger and ever more demanding responsibilities themselves.”

–       Axel Weber, former president of the Deutsche Bundesbank, interviewed on Radio 4’s ‘Today’ programme, 22 January 2015, just prior to Mario Draghi’s announcement of a €1.1 trillion ECB money-printing programme.

 

 

“The guy with the asset price bubble question.. he is not coming back.”

–       Tweet from Zero Hedge during the ECB press conference.

 

“When you look at Mr Wolf’s background … it becomes clearer why he supports these policies.  He’s never mortgaged his house to open a small business.  He lives in the fairy land of academics that believe printing paper will somehow be a signal to Directors (that have a fiduciary duty to act in the best interest of shareholders) to invest in expanding capacity?! ..that only the omnipotent power of the central planners can save the private sector by artificially holding down the major price signal in a ‘market’ economy.”

–       ‘Manfred’, responding to Martin Wolf’s FT piece, ‘Draghi’s bold promise to do what it takes for as long as it takes’, 22 January 2015.

 

“YOU KNOW THE BULL MARKET IS LONG IN THE TOOTH WHEN

“When….. Start-ups are being started and IPO’s being raised to hunt Bigfoot… Nope… this is not a joke…And nope, this is not something you would see anywhere near market lows.

From today’s WSJ:

Start-ups are famous for setting big, hairy goals. Carmine “Tom” Biscardi wants to catch Sasquatch—and is planning an initial public offering to fund the hunt.

Mr. Biscardi and his partners hope to raise as much as $3 million by selling stock in Bigfoot Project Investments. They plan to spend the money making movies and selling DVDs, but are also budgeting $113,805 a year for expeditions to find the beast. Among the company’s goals, according to its filings with the Securities and Exchange Commission: “capture the creature known as Bigfoot.”

–       Hat tip to Beijing Perspective. See also ‘Species of blue-green algae announces IPO’

 

Well, that was worth waiting for. Not. Future generations are unlikely to ask, ‘Where were you during the ECB’s announcement of QE, daddy ?’ Primarily because

a)    Much of the detail of the stimulus was leaked the day beforehand, and

b)    The real event of January was the Swiss National Bank’s capitulation in capping the franc’s peg to the euro.

Axel Weber’s assessment of the futility of euro zone QE is surely sufficiently articulate: a central bank is attempting to solve problems that can only be resolved through government action. A central bank by definition is limited in scope to the monetary sphere. What is required is tough love in the economic policy sphere – in France, in Greece, and elsewhere. Europe lacks the political and fiscal unity for Mario Draghi to do anything other than play games with the printing press and with a load of poor quality debt offering dubious yields. Central banks are not magicians, even if they behave like them.

And the ECB is coming late to the party in any case. In the words of Colin McLean, “the US and UK were dealing with a cyclical downturn, not deep-seated structural failure. In the euro zone, QE might further delay the need for structural reform..”

Financial historian Russell Napier last week discussed the Swiss National Bank’s surprise decision to abandon its own currency peg:

“The Swiss National Bank (SNB) failed to ‘fix’ the exchange rate between the Swiss Franc and the Euro. The simple lesson which investors must learn from this is – central bankers cannot fix very much. The inability of the Swiss National Bank to ‘fix’ the exchange rate will come to be seen as the end of the bull market in the omnipotence of central bankers.”

He went on to highlight some of the other things that investors erroneously believe central banks to have ‘fixed’:

“Central bank policy is creating liquidity.
Wrong –  the growth in broad money is slowing across the world.

“Central bank policy is allowing a frictionless de-gearing.
Wrong – debt to GDP levels of almost every country in the world are rising.

“Central bank policy is creating inflation.
Wrong – inflation in most jurisdictions is now back to, or below, the levels recorded in late 2009.

“Central bank policy is fixing key exchange rates and securing growth.
Wrong – in numerous jurisdictions, from Poland to China and beyond, this exchange rate intervention is slowing the growth in liquidity and thus the growth in the economy.

“Central bank policy is keeping real interest rates low and stimulating demand.
Wrong – the decline in inflation from peak levels in 2011 means that real rates of interest are rising. The growth in demand in most jurisdictions remains very sluggish by historical standards.

“Central bank policy is driving up asset prices and creating a positive wealth impact which is bolstering consumption.
Wrong – savings rates have not declined materially.

“Central bank policy is creating greater financial stability.
Wrong – whatever positive impact central banks are having on bank capital etc. they have failed to prevent the biggest emerging market debt boom in history. That boom is particularly dangerous because either the borrower or lender is taking huge foreign exchange risks and because a large proportion of that debt has been provided by open-ended bond funds which can be subject to runs.”

The ongoing disaster that is the euro zone is tedious beyond words, so let’s change the subject. The Washington Post last week published a piece on Venezuela (different circus; same clowns) by Matt O’Brien. This is another cautionary tale of what happens to economies when bureaucrats insist on messing around with the price function. Having “defaulted on its people”, Venezuela may now be on the verge of defaulting on its debts.

“It shouldn’t be this way. Venezuela, after all, has the largest oil reserves in the world. It should be rich. But it isn’t, and it’s getting even poorer now, because of economic mismanagement on a world-historical scale. The problem is simple: Venezuela’s government thinks it can have an economy by just pretending it does. That it can print as much money as it wants without stoking inflation by just saying it won’t. And that it can end shortages just by kicking people out of line. It’s a triumph of magical thinking that’s not much of one when it turns grocery-shopping into a days-long ordeal that may or may not actually turn up things like food or toilet paper.

“This reality has been a long time coming. Venezuela, you see, has the most oil reserves, but not the most oil production. That’s, in part, because the Bolivarian regime, first under Chavez and now Maduro, has scared off foreign investment and bungled its state-owned oil company so much that production has fallen 25 percent since it took power in 1999. Even worse, oil exports have fallen by half. Why? Well, a lot of Venezuela’s crude stays home, where it’s subsidized to the you-can’t-afford-not-to-fill-up price of 1.5 U.S. cents per gallon. (Yes, really). Some of it gets sent to friendly governments, like Cuba’s,in return for medical care. And another chunk goes to China as payment in kind for the$45 billion it’s borrowed from them.

“That doesn’t leave enough oil money to pay bills. Again, the Bolivarian regime is to blame. The trouble is that while it has tried to help the poor, which is commendable, it has also spent much more than it can afford, which is not. Indeed, Venezuela’s government is running a 14 percent of gross domestic product deficit right now, a fiscal hole so big that there’s only one way to fill it: the printing press. But that just traded one economic problem — too little money — for the opposite one. After all, paying people with newly printed money only makes that money lose value, and prices go parabolic. It’s no wonder then that Venezuela’s inflation rate is officially 64 percent, is really something like 179 percent, and could get up to 1,000 percent, according to Bank of America, if Venezuela doesn’t change its byzantine currency controls.

“Venezuela’s government, in other words, is playing whac-a-mole with economic reality. And its exchange-rate system is the hammer. It goes something like this. The Maduro regime wants to throttle the private sector but spend money like it hasn’t. Then it wants to print what it needs, but keep prices the same like it hasn’t. And finally, it wants to keep its stores stocked, but, going back to step one, keep the private sector in check like it hasn’t. This is where its currency system comes in. The government, you see, has set up a three-tiered exchange rate to try to control everything — prices, profits, and production — in the economy. The idea, if you want to call it that, is that it can keep prices low by pretending its currency is really stronger than it is. And then it can decide who gets to make money, and how much, by doling out dollars to importers at this artificially low rate, provided they charge what the government says.

“This might sound complicated, but it really isn’t. Venezuela’s government wants to wish away the inflation it’s created, so it tells stores what prices they’re allowed to sell at. These bureaucrat-approved prices, however, are too low to be profitable, which is why the government has to give companies subsidies to make them worthwhile. Now when these price controls work, the result is shortages, and when they don’t, it’s even worse ones. Think about it like this: Companies that don’t get cheap dollars at the official exchange rate would lose money selling at the official prices, so they leave their stores empty. But the ones that are lucky, or connected, enough to get cheap dollars might prefer to sell them for a quick, and maybe bigger profit, in the black currency marketthan to use them for what they’re supposed to. So, as I’ve put it before, it’s not profitable for the unsubsidized companies to stock their shelves, and not profitable enough for the subsidized ones to do so, either..

“.But just like Venezuela has defaulted on its most basic obligations to its people — like, say, laundry detergent — it might also default on its financial ones. It can’t afford anything, not food, not diapers, and not bond payments, if oil stays around $50 a barrel. Now, investors have assumed that they’d be able to seize Citgo, which is owned by Venezuela’s state-owned oil company, as payment if the country ever defaulted on its debt. But now it looks like that’s not true. That, together with falling oil prices, is why credit default swaps, basically debt insurance, on Venezuela’s 5-year bonds haveexploded the past few months. The fiscal situation is so dire that Citgo, which, remember, supposedly wouldn’t count as a part of the Venezuelan state, is planning on taking out $2.5 billion in debt to give to its parent company, which would presumably pass it along to the government. This makes sense, as much as anything does in Venezuela, because Citgo has a higher credit rating than the government, so it canborrow, and if it defaults, it will just be as if the country sold it.

“It’s a man-made tragedy, and the men who made it won’t fix it. Maduro, for his part, blames the shortages on the “parasitic” private sector, while the food minister doesn’t get what the big deal is since he has to wait in line at soccer games.

“So it turns out Lenin wasn’t just right that the best way to destroy the capitalist system is to debauch the currency. It’s also the best way, as Venezuela can tell you, to destroy the socialist one.”

At last week’s press conference to announce the ECB’s first iteration of QE (if history is any guide, there will be more), Mario Draghi claimed to see no evidence of inflation whatsoever. Perhaps Mario Draghi lets someone else manage his property, stock and bond portfolio.