New high! (Zzz.)

“The FTSE 100 has at last topped the record it set at the close of 1999. Should Britons celebrate ? Probably not.”

–       John Authers, The Financial Times, ‘FTSE hits record, but hold off the bubbly.”


“To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”

–       Warren Buffett, 10th December 2001.


“I’m thinking of making a purchase of Berkshire [Hathaway], but I’m concerned about something happening to you, Mr. Buffett. I cannot afford an event risk.”

–       Attendee at a shareholders’ meeting of Berkshire Hathaway.


“Neither can I.”

–       Warren Buffett’s response.


“The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.”

–       Benjamin Graham.


“Investors’ delight as shares smash record.”

–       The Times.


On the fiftieth anniversary of Warren Buffett’s taking control of the Berkshire Hathaway company, his annual letter to shareholders has been keenly anticipated. It does not disappoint. The compounded annualised gain in book value per share for the company from 1965 to 2014 equates to 19.4%. The annualised percentage gain for the S&P 500 over the same period, with dividends reinvested, equates to 9.9%. That differential has delivered astronomical comparative performance. The overall gain for the US market comes to 11,196% over the period. The overall gain for Berkshire Hathaway stock comes to 751,113%. If the efficient market hypothesis were correct, a differential of that magnitude could not possibly exist, in this or any other universe. As Buffett himself has remarked,

“I’d be a bum on the street with a tin cup if the markets were always efficient.”

So it is something of a shame that Buffett has never been awarded a Nobel prize for economics, as opposed to Eugene Fama, the father of the efficient market hypothesis, who has. No doubt Buffett’s net worth of roughly $60 billion takes some of the sting away.

Buffett in this year’s letter takes an explicit swipe at another piece of conventional investment wisdom – the idea that risk is essentially encapsulated in price volatility (step forward, Harry Markowitz, and any number of cheerleaders and ‘consultants’ who claim to be professional investors):

“For the great majority of investors.. who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities [i.e. cash and bonds]. If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement.”

In October 2009, Buffett’s business partner and Berkshire Hathaway Vice-Chairman Charlie Munger was interviewed on the BBC and was asked about how much concern he had for the company’s latest stock price decline. His response:

“Zero. This is the third time that Warren and I have seen our holdings in Berkshire Hathaway go down, top tick to bottom tick, by 50%. I think it’s in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by, say, 50%. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.” [Emphasis ours.]

There will be plenty of commentary online about Buffett’s letter and we don’t intend to distract readers from the source material. There’s just one line from it we’d like to reiterate:

“Although our form is corporate, our attitude is partnership.”

Berkshire’s structure is unusual. It’s a diversified holding company but clearly for many shareholders it has acted extraordinarily well as an investment manager. Berkshire and Buffett have benefited, in turn, from access to genuinely permanent capital and to unusually patient shareholders – a fact Buffett is only too happy to acknowledge. But the bottom line is that the relationship has been symbiotic: a partnership between co-investors, as opposed to an adversarial relationship between lots of mouths needing to be fed, and customers who are second in the queue for capital returns after all those mouths have been fed. As at year-end 2014, Berkshire was a business with $526 billion in assets, with a corporate headquarters employing just 25 people. Now that is decentralised capital allocation.

50 years. A 750,000% return. But the most striking thing about Warren Buffett at Berkshire Hathaway is not even the absurdly enviable track record of demonstrable investment success. The ‘value’ methodology, originally developed by Benjamin Graham, and subsequently adapted by Buffett to take account of Berkshire’s ever-increasing size, is almost entirely transparent, and a matter of historical record, not least in the Berkshire shareholders’ letters. Buffett himself acknowledged the perversity in his 1984 Appendix to Graham’s ‘The Intelligent Investor’:

“I can only tell you that the secret has been out for 50 years, ever since Ben Graham and David Dodd wrote ‘Security Analysis’ [and since Ben Graham followed up with ‘The Intelligent Investor’], yet I have seen no trend toward value investing in the 35 years that I’ve practised it. There seems to be some perverse human characteristic that likes to make easy things difficult..

“There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham and Dodd will continue to prosper.”

No, the most striking thing about Benjamin Graham, Warren Buffett, Berkshire Hathaway, and ‘value’ investing is why on earth anybody would want to invest any other way.


No need to say much more than the quotations cited above with regard to the latest non-event from the FTSE 100 index:

  • The new ‘high’ is only a high in nominal terms. As Merryn Somerset Webb points out, UK retail prices have risen by more than 50% since the last ‘high’ 16 years ago.
  • As the FT’s John Authers points out, the UK’s annualised real return of 1.4% since the last ‘high’ severely lags behind the rest of the world (2.1%) and even Spain (3.4%). And as Authers rightly also observes, the composition of the FTSE 100 is itself pretty arbitrary – 100 large companies, with particular concentration in banking and commodities, that just happened to list in the UK.
  • Per Buffett, if you are an ongoing consumer of UK stocks as hamburgers, this is actually bad news. It just means the market is more expensive.
  • If, like us, you have no interest in index-tracking, and are instead looking for compelling value, this is nothing more than a giant, irrelevant yawn. We are far more interested in what Ben Graham called “the ever-present bargain opportunities in individual securities”. Anglophile investors should be aware that there are currently more attractive sources of value in markets outside the UK and US.
  • This ‘news’ clearly appeals to those participants in the financial media for whom relevance to the real world comes secondary to the excitement and entertainment engendered by a good sports story.

The last word should probably to America’s finest news source.

From ‘The Onion’,back in 2000:

Blue Line Jumps 11 Percent

NEW YORK–Excitement swept the financial world Monday, when a blue line jumped more than 11 percent, passing four black horizontal lines as it rose from 367.22 to 408.85.

It was the biggest single-day gain for a blue line since 1994.

“Even if you extend the blue line’s big white box back many vertical lines, you won’t find a comparably large jump,” said Milton Vogel, a senior analyst with Merrill Lynch. “That line just kept going up, up, up.”

The blue line, which had been sluggish ever since the red line started pointing down in April, began its rebound with an impressively pointy 7 percent rise Friday. By noon Monday, it had crossed the second horizontal line from the top for the first time since December.

Ecstatic investors are comparing the blue line to the left side of a very tall, steep blue mountain.

“It’s a really steep line,” said Larry Danziger, a San Jose, CA, day trader and golf enthusiast. “I stand to make a tremendous amount of money as a result of the steepness of this line.”

“It looks like the line’s about to shoot out of the box,” said Boston-area investor Michael Lupert, enjoying a glass of white zinfandel on the bow of his 30-foot yacht. “I’m definitely going to keep a close eye on this line as it continues to move to the right.”

Despite such bullishness, some financial observers are urging caution.

“Given this line’s long history of jaggedness, we really should take a wait-and-see approach,” Fortune magazine associate editor Charles Reames said. “And even if this important line continues its upward pointiness, we must remember that there are other shapes, colors, numbers, and lines to consider when judging the health of the economy.”

Reames also warned that the upward angle of the line, which most analysts agreed was approximately 80 degrees, may have been exaggerated by the way the graph was drawn.

“The stuff that’s written along the bottom of the graph is all squished together, making the line look a lot more impressive than it is,” Reames said. “Had that same stuff been spread out more, the line would have looked a lot less steep.”

Still, most U.S. investors found it hard to contain their enthusiasm as the blue line shot up sharply, outperforming the green line, the yellow line, and even the thriving dotted purple line.

“Typically, the blue line rises or falls no more than 10 in a day,” said Beverly Hills plastic surgeon Dr. Jeffrey Gruber. “But Monday, it went up an astonishing 41–and during a time when we have a big red slice showing on our pie charts, no less. We live in a truly remarkable time.”



A World In Debt

In his magisterial 1936 work, ‘A World in Debt‘, Freeman Tilden treated the business of contracting a loan with a heavy serving of well-deserved irony, describing how the debtor gradually mutates from a man thankful, at the instant of receiving the funds, for having found such a wise philanthropist as is his lender to one soon becoming a little anxious that the time for renewal is fast approaching. From there, he turns to the comfort of self-justification, undertaking a little mental debt-to-equity conversion in persuading himself that his soon-to-be disappointed creditor was, after all, in the way of a partner in their joint undertaking and so consciously accepted a share of the associated risks.

Next he adopts an air of righteous indignation at the idea that he really must redeem his obligation on the due date, before rapidly giving into a growing fury in contemplation of how this wicked usurer has duped him into contracting for something he cannot hope to fulfil, as so many poor fools before him have similarly been entrapped by this veritable shark.

Likewise, our author quotes the 19th century utilitarian, Jeremy Bentham, to much the same effect.

‘Those who have the resolution to sacrifice the present to the future are natural objects of envy’ for those who have done the converse, our sage declared, like children still with a cake are for those who have already scoffed theirs. ‘While the money is hoped for… he who lends it is a friend and benefactor: by the time the money is spent and the evil hour of reckoning is come, the benefactor is found to… have put on the tyrant and the oppressor.’

Here we should realise the pointlessness of trying to decide whether the Greeks or the Germans are at fault in the present impasse and press on toward the crux of the matter. As Tilden rightly argued about the consequences of a bust:-

‘It follows that any scheme looking towards the avoidance of panics and depressions must deal with this cause [viz., debt] and any plan that does not do so is not only idle, but may be a dangerous adventure.’

‘Hence, the way to deal with a collapse of exchange is not to pretend that “prosperity” is merely in a temporary eclipse, to return again if everybody will act optimistically; but frankly to acknowledge that conditions were unsound, and to permit the natural impulses of trade to rectify them. This prescribes a bitter medicine, which people do not like and politicians cannot collect upon, but quack remedies merely put off the final reckoning.’

Are you listening, Mario?

‘The natural remedies, if the credit-sickness be far advanced, will always include a redistribution of wealth: the further it is postponed, the more violent it will be. Every collapse of credit expansion is a bankruptcy and the magnitude… will be proportional to the magnitude of the debt debauch. In bankruptcies, creditors must suffer.’

The problem with our modern world is that the ‘quack remedies’ we most routinely favour are ones which involve adding another layer of ‘debt debauch’ on top of the still uncleared detritus of the previous one. If you doubt this, I must ask what else, pray, do you think is entailed by QE in all its many variants if not the attempt to find new, biddable debtors to take the place of the grumbling, undischarged old ones?

Even if you are loth to accept this line of reasoning, you surely must concede that a ‘putting-off of the reckoning’ comes with many disadvantageous features and several self-aggravating tendencies and that this should be obvious enough to anyone with sufficient intellectual honesty to consult the record of the past few years – if not decades – objectively.

Firstly, it encourages a wasting forbearance of dead or dying enterprises in a kind of lunatic refusal to recognise that the associated costs are well and truly sunk and that the only valid criterion for continued investment is the judgement that the undertaking will be viable from today, not whether we can thereby avoid booking the losses incurred by it yesterday. Such ‘zombification’ retards, if not prevents, the necessary reallocation of men, machinery, and financial means toward more profitable (and hence more socially beneficial) employment. By propping up the diseased trunks of the past, it prevents light and nutrients from reaching the thrusting saplings of tomorrow. Creative destruction is out and destructive continuation is in to the detriment of all.

Worse, yet, the feeble, ‘stimulus’-dependent manifestation of growth which does then occur leads to that dreadful, anti-Hippocratic impatience to which all our electoral cycle overlords are prone. Bad policy thus leads to more bad policy – whether by way of simple reinforcement of ineffective treatment or by jejune ‘innovation’. As more and more market signals become scrambled, as larger and larger swathes of the economy are turned over either to run-‘em-for-cash basket cases or to newly malinvested Bubble 2.0 entrants upon the stage, the space for genuine entrepreneurship becomes progressively restricted. Growth therefore slows, cycle after cycle, until men in authority – who really should know better – start to mutter rehashed 1930s pessimism about ‘secular stagnation’.

Compounding all this, of course, is the awful truth that practitioners of mainstream economics are in thrall to age-old underconsumptionist fallacies and so require – nay, demand – that no debt must ever be paid down in aggregate (or, as they like to put it, in order to give the idea a thin sheen of respectability, the total of outstanding credit must never fall). Thus, with each successive cycle, new strata of debt are laid down upon the barely eroded bedrock of stale, older ones. Thus it is that the burden of servicing such a growing mountain of claims – an orogenesis of obligation, we might say – can only ever go up. In turn, this results in the officially-imposed interest rate cycle becoming more and more truncated, with each peak lying below the preceding one and with each trough being pushed to – and lately through – the zero bound so that the income drain imposed by that tower of debt does not become too onerous or the old problems re-emerge with renewed venom.

As official rates trend downward, the private sector usually seeks to go one better. Knowing that the debt principal holds little place in the popular imagination but that the monthly payment is the true determining factor in the bargain, lenders start to push out maturities and/or forego the requirement that loans should be smoothly amortized. Not only does this allow the already-indebted both to refinance and then to add to the sums they owe, but it helps entice new cohorts of previously unwelcome borrowers to live beyond their means as well. A fifty-year mortgage or an eight-year car loan? Step this way, sir, we’ll see what we can do.

Soon so much income has been alienated – much of it for such entirely unproductive purposes that little extra earning potential has been acquired in the process – that what we call the intertemporal imbalances again become insupportable. In the current jargon, so much spending has been ‘brought forward’ to prop up today’s faltering system that ever more desperate measures are required to find new expenditures to accelerate and new prodigals to accelerate them when arrives that tomorrow whose fruits we have ‘brought forward’ and the orchard is seen to have been long since stripped bare of its bounty.

On top of this, the eradication of any appreciable opportunity cost in keeping money for its own sake in preference to owning one of the many recognisable claims on greater future money payments (loans, bonds, etc.) leads to a dilution of the principal source of demand for money, the one only transiently expressed in respect of its imminent use as the medium of exchange. This not only confuses the indicators by which we try to balance today’s thrift with tomorrow’s hopes of improved output, but it begins to poison the monetary manipulators’ own wells, to boot.

Accordingly, if money is seen as conferring no great disadvantage should one hold it in place of an ultra-low yielding bond, then the disingenuous assertion first made by Chairman Bernanke that QE is not inflationary because it comprises nothing more than an ‘asset swap’, starts to become all too true.

The central authority, desirous of creating just such an inflation out of a predominant fear of the effect of flat or falling prices on all those whom it has been ceaselessly exhorting to continue to overborrow, easily generates base or ‘outside’ money on which new loans could theoretically be pyramided. But, alas, the commercial banks passively book a good part of these reserves as the primary balance sheet counterparts to the largely inactive settlement deposits of the sellers of the bonds earlier ‘swapped’ for them. Thus, excess reserves do not induce the creation of many additional earning assets – and hence of ‘inside’ money deposits – on top of the original influx.

Moreover, where those same depositors do start to feel their trouser pockets heating up, they typically start to play pass-the-parcel with one another by engaging in a bidding war for bulk credits or listed equities on the financial market, inflating their values and further reducing yields below their optimum levels. What they do not do is rush out and make loans to small businessmen so that these latter earnest souls can improve their capital stock or expand their workforce, no matter what M. Sarkozy may have blustered in 2008 about wanting to ‘…put down the foundations of a capitalism of the entrepreneur and not of the speculator’ as a response to the ongoing financial apoplexy.

With barely a nod to the operation of the much vaunted ‘transmission channels’ so beloved of academia, real-side monetary ‘velocity’ is therefore seen to decline and before too long, the central bank is casting about again for new, more ‘unorthodox’ ways to engineer a perceived surfeit of money and hence to promote a more rapid transactional circulation of the stuff. The vicious circle takes another turn as it does: rates decline further across the curve and yet both borrowing and real-side activity are again only modestly excited.

Before long, men in authority – who really should know better – start to mutter freshly cooked forms of idiocy, claiming that the ‘natural’ rate of interest has fallen to a negative value – a state of affairs in which they must imagine that all of us intemperate, impatient, indulgent mortals have somehow switched en masse to a rare preference for the delayed, rather than the instant, gratification of our wants. Even worse, they find no paradox in supposing that the inexhaustible Horn of Plenty, without which no such unmitigated satiation can have been brought about, must have made its wondrous appearance in a period of mass unemployment and so, presumably, also one of mass want.

In the Looking Glass world of ‘secular stagnation’ and ‘negative real natural rates’ to which all this monetary accommodation has supposedly consigned us, can you guess what the prescription for a restoration of normality must be? Of course! A determined effort to swamp the world with yet more central bank money, to further suppress interest rates, to co-opt more of the decision-making to the central planners, and to annexe more of the economic realm to the fiefdoms of Frankfurt, Washington, and Threadneedle St.! Whatever it takes, don’t you know?

So, with all that said, we come today to yet another major confrontation between lender and borrower in the respective shape of Germany and Greece, one which has foolishly been delayed for more than seven years by the unshakable intransigence of those in power.

This all began with the early crisis vainglory that ‘no strategic bank will fail – and, yes, they are all strategic’. It continued into 2010 when M. Trichet pointed his metaphorical revolver of the refusal to continue with emergency support right at the head of the unfortunate Irish Finance Minister Brian Lenihan – a kind of financial Melian dialogue which the Greeks seem to have well taken to heart, now that such threats are being repeated once more. It rolled on and on with the efforts of the so-called Troika and with the ever-changing, but never truly effective programmes of the ECB itself. It mounted with the widespread abuse of Target2 – something that is, after all, supposed to be a clearing system, not a continent-wide credit wrapper – and with the inordinate strain placed on the balance sheet of the neighbouring SNB.

All the while, the insidious transfer of debt from the private sector to the state (or at least to banks which could not survive absent either explicit or implicit support from that state) has continued, so rendering the necessary resolution between creditor and debtor too diffuse, too indirect, and too legally undefined ever to achieve.

Pity then a Greece which is unfortunate enough to be stuck at Europe’s bottom-right corner instead of at Asia’s top-left, or an Iberian peninsula separated from its neighbours by the Pyrenees to the north rather than by the Atlas mountains to the south, for can we find it at all conceivable to think that they would both not have long ago have seen their debts meaningfully restructured, much of their dead wood cut away, and many of their people set back on the road to prosperity if they had been ‘emerging market’ nations and not satrapies subject to the reality-denying Canutes who run the EU?

For all the hand-wringing about ‘mindless austerity’ on the part of that economic luminary who occupies the Oval Office between golf rounds and for all the wailing conducted over ‘deleveraging’, the sorry truth, of course, is that neither a shrinkage of government outlays nor an overall reduction in debt levels is to be found in even the smallest corner of the globe.

15-02-11 McK Debt

To take one much quoted recent study, this month’s McKinsey report estimates that, since the start of the Crisis in 2007, global debt has risen by some $57 trillion (so, by around $8,000 for every man, woman, and child on the planet) with almost exactly half of the increase in the sub-total attributable to non-financial entities being the fault of those oh-so heartlessly austere governments who have run up an additional tab of a cool $25 trillion in that brief space of time! This means that, in the 6 ½ years of slump and reflation, Leviathan has treated himself to almost $11 billion a day in deficit spending, a sizeable deterioration of almost 2 ½ times the paltry $4.3 billion it was gobbling up during Pharaoh’s preceding seven years of plenty.

It may not be enough to satisfy a Krugman or a Lagarde, but for our taste that represents a dreadfully large quota of capital either frozen in place, shovelled (sometimes literally) into sub-marginal, make-work projects, or simply squandered on recipients of welfare – whether corporate, individual, or among the serried and largely sacrosanct ranks of the place-holding bureaucracy.

15-02-11 APAC v ROW

Looking instead to the subset represented by the BIS numbers for ‘global liquidity’ – i.e., the loans extended to and securities bought by banks from non-bank borrowers –we see a similar picture. Since Lehman fell, $25 trillion has been added to this particular pile, an increase of one-third from its starting point. Somewhat alarmingly, two-fifths of that increment has its origins in the Asia-Pacific combination of China, Taiwan, Indonesia, India, Korea, Malaysia, the Philippines, and Thailand. Indeed, the last twelve months’ 21.4% increase in cross-border lending to the region has capped off a nearly 80% rise in debt owed by this octet in the period under consideration. To gain some perspective on the magnitude of this, it should be noted that the $10.3 trillion which this involves matches the sums jointly accumulated by governments, households, and non-financial companies in the whole of Europe, the US, Japan, and Latam put together.

Inflation is a rich man's game
Inflation is a rich man’s game

A sizeable proportion of that, it almost goes without saying, lies at the door of the Chinese and, coincidentally, the PBoC has been gracious enough this week to reveal its estimate of what it calls Total Social Finance (a hybrid of bank and non-bank credit, together with a smattering of non-bank equity issuance) – an inclusive agglomeration which the likes of Fitch would argue even so does not in any way account for the whole of the web of obligations being woven so densely across the Middle Kingdom.


Nevertheless, the totals we are given are impressive enough. As of the end of last year, the central bank reckons that TSF outstanding came to CNY124 trillion (around $20 trillion). Having pretty much been stable at a ratio of just over 120% of GDP in the prior six years, the massive stimulus programme unleashed in the immediate aftermath of the GFC and never truly attenuated since has seen the credit measure more than triple in absolute size the most recent six, pushing the ratio dangerously skyward to 193% of national income.

15-02-11 TSFvGDP

This is the legacy whose baneful influence makes up those ‘Three Overlays’ of debt overhang, surplus capacity, and urgent restructuring with which Beijing likes to remind us it has to tussle on the (Silk) road to its ‘new normal’ of slower, more rational growth, and more market-oriented, value-added activity.

So here we have both a major peril and a possible source of hope. The Chinese authorities appear to have recognised that, by following the practices preached by the execrable Western mainstream – albeit on a truly gargantuan, command-economy scale – it has gone beyond the bounds of merely diminishing to reach the Omega point of no return.

So far, as its economy has stuttered and stumbled along, it has resisted the temptation to add just one last, generous coup de whiskey in order to postpone the inevitable hangover (which does not mean it has been entirely abstemious since the new boys took over in 2013). But now not only is growth stuttering, but many prices are falling, too – principally, if not exclusively, those of the raw materials for which it has such a voracious appetite. However beneficial this discount may be to cash-strapped processing firms, it has nevertheless raised the bogey of so-called ‘deflation’ in the counsels of the wise

The question therefore presents itself: will Xi and Li stick to their guns and rely on broader micro-economic and institutional reform to foster a national renaissance – albeit one backed up with a little judicious concrete pouring ‘Along the Way’, i.e., along the route of the new trade routes being constructed to Europe? Or will the pressure to deaden the pain in the interim prove too intense and so unleash both indiscriminate policy easing and possibly an export-boosting devaluation of the yuan?

So far, all the signals are that they will resist the urge, despite a barrage of domestic commentary to the contrary, but a great deal hangs on the fortitude of Xi himself, that one lonely man, perched at the top of the CCP hierarchy – an organisation which itself sits uneasily at the very peak of a true Mount Olympus of debt.


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.

Book Reviews

The Greatest Depression You’ve Never, Ever Heard Of

James Grant, in his new book The Forgotten Depression, makes a strong case for applying a prime directive of the Hippocratic Oath — “First, do no harm” — to economic policy. We today find ourselves beset by economic stagnation, racial strife, political bitterness, infectious diseases, and terrorism. Grant brings back to mind some of the direness of the days of yore, making our current condition seem a pale echo.

By the contemporary reckoning of the English economist T.E. Gregory, the world in 1921 was “nearer collapse than it has been at any time since the downfall of the Roman Empire.” Certainly, in America, there was no mistaking the postwar zeitgeist with the Era of Good Feelings. Preceding the race riots and Red scare of 1919-20 was the worldwide influenza pandemic of 1918-19; it killed 40 million people, including 675,000 Americans. With the advent of Prohibition in January 1920 a major industry was outlawed (yes, said the evangelist Billy Sunday, but “Hell will be forever for rent.”) On September 16, 1920, a terrorist explosion on Wall Street killed 38 and wounded 300. Later, in September, a grand jury started hearing evidence into the Chicago White Sox’s alleged fixing of the 1919 World Series.

A 1920 recession turned into a 1921 depression…. This was no mere American dislocation but a global depression ensnaring nearly all the former Allied Powers (the defeated Central Powers suffered a slump of their own in 1919).

So depression it was: What would the government do about it? It would implement settled doctrine, as governments usually do. In 1920-21, this meant balancing the federal budget, raising interest rates to protect the Federal Reserve’s gold position, and allowing prices and wages to find a new, lower, level. Critically, what it would not do was what the Hoover administration so energetically attempted to do a decade later: there would be no federally led drive to maintain nominal wage rates and no governmentally orchestrated work sharing. For this reason, not least, no one would wind up affixing the label “great” on the depression of 1920-21.

The Forgotten Depression fundamentally is Grant’s deep look into the sharp but short depression of 1921 and his challenge to Neo-Keynesianism, the settled economic doctrine of our era. Grant draws out implications from comparing that painful but relatively brief event with the long misery of the Great Depression and, by implication, with the recent, protracted, Great Recession.

Grant likely is the greatest belle-lettrist (and one of the greatest narrative historians) of our generation’s economic neoclassicists. He is learned, erudite, witty, with an eye for the telling detail. Posterity might consider Grant our era’s Bastiat. The Forgotten Depression is filled with vivid personalities, wisdom and folly, ecstasies and agonies.   It brings to fresh life an era that is far more forgotten than it is forgettable.

Grant provides abundant wry observations that make most of the conventional wisdom of Washington’s political elites today appear foolish. We confront a dilemma, however, one which Grant does not resolve. It might be irresolvable. A severe economic downturn causes immense human suffering. The estimable quality of empathy beckons those in authority to alleviate such suffering.

Grant gives the great technocrat Herbert Hoover full credit for such empathy:

No one could doubt Herbert Hoover’s generosity of spirit, even if the secretary of commerce had none of Harding’s personal warmth. The war plunged them (Hoover and his wife) into public service. An estimated 120,000 Americans had been stranded in Europe by the outbreak of the fighting. The Hoovers devoted themselves to the costly and complex logistical task of getting the travelers home. When it came to light that millions were hungry in German-occupied Belgium, Hoover became a pro bono battler against starvation. Later, after America joined the war, he headed the U.S. Food Administration. With the peace, he led the American Relief Administration. Millions owed their health, if not their lives, to the man who now served as Harding’s secretary of commerce.”

And yet, the road to Hell is paved with good intentions.

Without what would come to be called “macroeconomic” intervention by the government the Roaring ‘20s swiftly followed the “Forgotten Depression.” Then … Black Tuesday would ensue. As Keynes said  to aSaturday Evening Post reporter, in 1932, who asked if there had ever been anything like the Great Depression: “Yes. It was called the Dark Ages and it lasted 400 years.”

The aggressive measures implemented by President Hoover and then by FDR, Grant lucidly argues, protracted what otherwise might have been a short downturn into a decade of perhaps the longest era of economic misery America has experienced.

I (along with Hayek) stipulate to Keynes’s great-heartedness. That said, Grant indicts Keynes, along with Irving Fischer, as the authors of a fundamental conceptual shift of policy that led to the protraction of a major recession into the Great Depression. Grant:

Economists on both sides of the Atlantic were making the case for a new kind of monetary system. Under the pre-war gold standard, exchange rates were fixed and inviolable. If something had to adjust, that something was business or employment or prices, not the gold value of money. Better by far in the postwar world, contended John Maynard Keynes and Irving Fisher, if prices remained stable while currency values were allowed to adjust. To achieve the great desideratum of “price stability,” the theorists advocated a new style of central banking. … The mark of success in central banking was no longer a currency fully convertible into gold at a fixed and statutory rate. It was stable prices and lots of jobs.”

These very objectives remain with us. The statutory mission of the Federal Reserve System has been called the “dual mandate.” It is price stability and full employment. Were it capable of “targeting” these outcomes successfully a great leap forward indeed would have been made in human welfare.

Yet according to the Bank of England’s Financial Stability Paper No. 13, published in December 2011, all economic outcomes under the current monetary regime — notably price stability and employment —have underperformed — dramatically —both the gold and the Bretton Woods gold-exchange standard.

It now may be intolerable, politically, for a government to do nothing to alleviate the deep misery associated with a recession. That said, not all interventions are equal. Although not quite brought to the fore by Grant it might be possible for the government to provide fast — virtually immediate — relief by doing the right thing thereby honoring both the economic and the political imperatives.

It is hard to imagine a state of greater destitution than that of the exhausted, bombed out, Germany financially ruined by the Nazis and its infrastructure and industry demolished by allied forces. As I previously have written Ludwig Erhard’s Wirtschafswunder — the German Economic Miracle — began on a dime, as recorded by Erhard in Prosperity Through Competition quoting Jacques Rueff, whom Grant mentions but briefly, and Piettre:

Shop windows were full of goods; factory chimneys were smoking and the streets swarmed with lorries.  Everywhere the noise of new buildings going up replaced the deathly silence of the ruins.  If the state of recovery was a surprise, its swiftness was even more so.  In all sectors of economic life it began as the clocks struck on the day of currency reform.  Only an eye-witness can give an account of the sudden effect which currency reform had on the size of stocks and the wealth of goods on display.  Shops filled with goods from one day to the next; the factories began to work.  On the eve of currency reform the Germans were aimlessly wandering about their towns in search of a few additional items of food.  A day later they thought of nothing but producing them.  One day apathy was mirrored in their faces while on the next a whole nation looked hopefully into the future.

Rueff, with Pinay, later engineered the French “Economic Miracle” founded on comparable principles. Prosperity, not austerity, is the means as well as the ends.

There is a third way between doing nothing and doing the wrong thing. Grant observes, rightly, that government typically implements “settled doctrine.”  Settled doctrine has a poor track record.  Time to pivot back to what has proven to work in practice.

As the late presidential economic advisor Walter Heller once observed to Congress, in 1985, sometimes one must “Rise above principle and do what’s right.” The Forgotten Depression would be a suitable place for our policy makers to begin to tousle the settled doctrine and embrace policies that will return us to to robust job creation and economic mobility.

Originating at


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.


“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****** 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.



Swiss National Bank abandons franc’s cap against the euro

On January 15th 2015 the Swiss National Bank (SNB) has announced an end to its three year old cap of 1.20 franc per euro. (The SNB introduced the cap in September 2011). The SNB has also reduced its policy interest rate to minus 0.75% from minus 0.25%. The Swiss franc appreciated as much as 41% to 0.8517 per euro following the announcement, the strongest level on record – it settled during the day at around 0.98 per euro.

We suggest that the key factor in determining a currency rate of exchange is relative monetary pumping. Over time, if the rate of growth of money supply in country A exceeds the rate of growth of money supply in country B then that country’s currency rate of exchange will come under pressure versus the currency of B, all other things being equal.
Whilst other variables such as the interest rate differential or economic activity also drive the currency rate of exchange, they are of a transitory and not of a fundamental nature. Their influence sets in motion an arbitrage that brings the rate of exchange in line with the influence of the money growth differential.
We hold that until now the rise in the money growth differential between Switzerland and the EMU during July 2011 and April 2012 was dominating the currency rate of exchange scene. (It was pushing the franc down versus the euro).The setting of a cap of 1.20 to the euro to supposedly defend exports was an unnecessary move since the franc was in any case going to weaken. The introduction of the cap however prevented the arbitrage to properly manifest itself thereby setting in motions various distortions. (Note again the money growth differential was weakening the franc versus the euro).
A fall in the money growth differential between April 2012 and April 2013 is starting to dominate the currency scene at present i.e. it strengthens the franc against the euro. So from this perspective it is valid to remove the cap and allow the arbitrage to establish the “true” value of the franc. (This reduces the need to pump domestic money in order to defend the cap of 1.20). Observe that as opposed to 2011, this time around, by allowing the franc to find its “correct” level the SNB it would appear has decided to trust the free market.
Note that since April 2013 the money growth differential has been rising – working towards the weakening of the franc versus the euro – and this raises the likelihood that the SNB might decide again some time in the future on a new shock treatment.



We hold that by tampering with the foreign exchange market the SNB sets in motion fluctuations in the growth momentum of money supply (AMS) and this in turn generates the menace of the boom/bust cycles. (Note the close correlation between the fluctuations in the growth momentum of foreign exchange reserves, the SNB’s balance sheet and AMS).



Also, observe that by introducing the cap and then removing it the SNB, contrary to its own intentions, has severely shocked various activities such as exports. Note that the SNB is supposedly meant to generate a stable economic environment.


Should a Bank in Difficulties Receive Assistance?

This was the question put to me by Treasury Committee Chairman Andrew Tyrie MP when I appeared before the Committee on January 6th to give evidence on the Bank of England’s latest Financial Stability Report.

This is a question to which many of us on our side have given much thought and I believe it to be the single most important question in the whole field of bank regulatory policy.

I was nonetheless caught off-guard when Mr. Tyrie asked it at the beginning of the session – I was expecting questions on the Bank’s latest nonsense, the results of its new stress tests – and my initial response was less than it should have been. But no excuse: it was a perfectly reasonable and entirely foreseeable question – the obvious question, even – and I still didn’t see it coming. Reminds me of the blunders I would occasionally make when I played competitive chess: I obviously haven’t improved much.

Thankfully, he asked me the same question again at the close of the session, and his doing so allowed me to give the correct answer clearly, an emphatic ‘No’. However, by this point there was no time to elaborate on the reasons why a bank in difficulties should be denied assistance.

These reasons go straight to the whole can of worms and my follow-up letter to Mr. Tyrie should, I hope, help to set the record straight.

My message to other advocates of free markets is that leaving aside the usual bailouts-are-bad stuff, we really should give more thought to what an Armageddon Plan B might look like: Yes, no bailouts would be best, even in our intervention-infested system, but in that case why do we humour lender-of-last-resort and, more to the point, if the government is even considering intervention in what it (rightly or wrongly) sees as an emergency in which something-really-ought-to-be-done-NOW, then what should we advise it to do – other than ‘Don’t’?

Mark my words: if we don’t give the government constructive advice, it will do what it always does when a crisis breaks out: it will panic and the chances of any sensible policy response will be zero.

So here is the text of the letter, dated January 12th:

“Dear Mr. Tyrie,

I would like to thank you for the opportunity to give evidence to the Treasury Committee at its meeting on January 6th.

At that meeting you asked me if the authorities should assist a bank that gets into difficulties.

My answer is ‘No’ but I should like to elaborate.

Consider first a free or laissez-faire banking system in which there is no central bank, no financial regulation and no other state interventions such as deposit insurance. In such a system, competitive pressures would force the banks to be financially strong; bankers who ran down their banks’ capital ratios or took excessive risks would eventually lose their depositors’ confidence and be run out of business, so losing their market share to more conservative and better-run competitors. Bankers themselves would have serious skin in the game and therefore have strong incentives to keep their banks sound: for them, bank failure would be personally costly. Banks would then be tightly governed and conservatively risk-managed, and the banking system as a whole would be highly stable.

There would still be occasional failures due to the incompetence of individual bankers, but these would be few and far between, and not pose systemic threats.

These claims from free-banking theory are broadly confirmed by the historical experiences of the many free or loosely regulated banking systems of the past, most notably the experiences of Scotland pre-1845 and 19th century Canada.

In such a system, there is no good case for official assistance to any bank in difficulties. A bank failure would be painful to those involved, but the possibility of bankruptcy is unavoidable in any industry in a healthy capitalist economy, and this includes the banking industry. Letting a badly run bank fail also sends out the right signals – it encourages other bankers to avoid the same mistakes, it encourages depositors to be careful with the banks they choose and it avoids the moral hazards inevitably created by any policy of assistance.

Modern banking systems differ from these systems because of the presence of extensive systems of state intervention, including a central bank, a central bank lender of last resort function, deposit insurance, capital adequacy regulation and other forms of financial regulation. In different ways, each of these interventions makes the banking system less stable: central banks through erratic and usually loose monetary policies, which create inflation and fuel asset price cycles, and generally destabilise the macroeconomy; the lender of last resort and deposit insurance by creating moral hazards that lead to excessive risk-taking by bankers; capital regulation by creating short-termist incentives for banks to reduce their capital (e.g., by playing games with risk models and risk weights); and financial regulation generally by its large compliance costs and its stifling of innovation. Over time, these interventions have made the banking system weaker and weaker, even though their usual stated intention was to strengthen the banking system rather than to weaken it.

However, even with the banking system already seriously weakened by a long history of misguided government interventions, the best policy response is still to refuse assistance to banks in difficulties. I say this for two main reasons:

  • the systemic effects of bank difficulties tend to be exaggerated even in a systemic crisis, sometimes grossly so; and

  • interventionist policy responses tend to make matters even worse.

The ideal response by policymakers is to refuse assistance point-blank – and to announce such a policy in advance so the bankers know where they stand.

Policymakers should follow the advice of Lord Liverpool, who was PM at the time of the last systemic banking crisis pre-2007, that of December 1825. In May that year, he foresaw the looming crisis and warned the House of Lords about the “general spirit of speculation, which was going beyond all bounds and was likely to bring about the greatest mischief on numerous individuals.” He wished it to be “clearly understood” that those involved “entered on their speculations at their own peril and risk” and he thought it his duty to declare that he would “never advise the introduction of any bill for their relief; on the contrary, if any such measure were proposed, he would oppose it” and he hoped Parliament would reject it.

In our current system such a response would require political leadership with uncommon vision and nerves of steel. When the next crisis occurs, it will explode unexpectedly, taking policymakers off guard. They will be under extreme pressure to respond quickly – probably within hours – on the basis of inadequate information, whilst bankers lobby intensely for immediate assistance: if we don’t get bailed out, the world will end, etc., the usual scare mongering. Under such circumstances, it would be extremely difficult for even the best political leadership to avoid being dragged into making the same mistakes made repeatedly in previous crises.

These mistakes include:

  • panicky rescues, which are later shown to be unnecessary, ill-judged and in some cases illegal;

  • the abandonment of previous ‘commitments’ to let badly run institutions fail;

  • bankers being rewarded for their failures by being made personally better off than they would have been had their banks been allowed to fail; and

  • more regulation or regulatory reshuffles accompanied by the usual empty promises that ‘it’ won’t happen again, made by the very people who had no idea what they were doing when they were in charge the last time round.

So how can we avert such outcomes? A good start would be an Act to prohibit future assistance: as much as possible within the confines of our constitution, we should seek to tie the government to the mast. “Much as I would like to help you”, the PM can say, “my hands are tied.”

But even with this Act in place, there is still the difficult question: if the government does respond to the next crisis, then what should it do?

To that question I would propose a publicly disclosed Plan B, whose main features would include:

  • a programme to keep the banking system as a whole operating at a basic level to prevent widespread economic collapse;

  • fast-track bankruptcy processes to resolve problem banks and, where possible, return them to operation as quickly as possible;

  • a prohibition of cronyist sweetheart deals for individual banks or bankers;

  • provisions to ensure that senior managers of any failed banks are made strictly liable to severe personal financial penalties;

  • a holding-to-account of senior bankers, regulators and policymakers, including the opening of criminal investigations into the activities of any banks that fail;

  • the establishment of a legal regime that imposes high standards of personal liability on senior bankers;

  • the restoration of sound accountancy standards; and

  • a radical programme to deregulate the banking industry.

This programme would include the abolition of the current regulatory structure including the PRA and FCA, the ending of deposit insurance, the UK’s withdrawal from the Basel system of capital regulation, and the reform (and preferably, abolition) of the Bank of England. These reforms would rein-in the out-of-control moral hazards that permeate our current banking system and restore the personal responsibility, tight governance and conservative risk-taking that are the keys to a sound banking system.

Contingency planning for the next crisis should also provide for only two possible responses by the authorities: either Plan A (i.e., do nothing) or Plan B as just set out. Any intermediate response should be prohibited, as that would merely open the door to the usual mistakes that the authorities are prone to make in such circumstances.

In short, in response to your question about whether a bank should receive assistance, my answer would be ‘No’, but if we are to avoid another bungled policy response when the next crisis occurs it would be wise to have a credible Plan B in place to address upfront the Armegeddon scenario of a possible systemic collapse. And if it does intervene, the government should use the opportunity to clean up banksterism once and for all and restore a sound banking system based on the principles of personal responsibility and laissez-faire.

Yours Sincerely

Kevin Dowd,

Durham University/Cobden Partners [etc.]”

There is a lot more to say on this subject, but one of the points that emerges most clearly for me is the pressing need for free-market narratives of the financial crisis, blow-by-blow accounts of how it should and might have been. In this context – and off the top of my head – I would particularly recommend the following (with apologies to those whose work I have overlooked):

John A. Allison, The Financial Crisis and the Free Market Cure, McGraw-Hill 2013, esp. chapters 14-17.

Richard Kovacevich, “The Financial Crisis: Why the Conventional Wisdom has it All Wrong”, Cato Journal Vol. 34, No. 3 (Fall 2014): 541-556.

Vern McKinley, “Run, Run, Run: Was the Financial Crisis Panic over Institution Runs Justified?Cato Policy Analysis 747, April 10, 2014

George A. Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents its History and Performance”, Cato Journal Vol. 34, No. 2 (Spring/Summer 2014): 229-263.

These are all US-oriented of course and we badly need to work on similar narratives for the UK, Ireland and Europe.

But going back to the Treasury Committee, most of the discussion was on the regulatory risk models – or more precisely, on what is wrong with regulatory risk modelling and in particular, the Bank’s stress tests. I have to say, too, that I was greatly heartened to see the skepticism of the MPs towards the models and their openness towards our ideas, much of which is obviously down to the pathbreaking work that Steve Baker is doing on the Committee. But let me come to all that in another posting.


Greece, Germany and the ECB: and what it means for Bonds, Stocks and the Euro

Greece is back in the spotlight amid renewed fears of a break-up of the Euro as the Syriza party show a 3.1% lead over the incumbent New Democracy in the latest Rass opinion poll – 4thJanuary. The average of the last 20 polls – dating back to 15th December shows Syriza with a lead of 4.74% capturing 31.9% of the vote.

These election concerns have become elevated since the publication of an article in Der Spiegel Grexit Grumblings: Germany Open to Possible Greek Euro Zone Exit -suggesting that German Chancellor Merkel is now of the opinion that the Eurozone (EZ) can survive without Greece. Whilst Steffen Seibert – Merkle’s press spokesman – has since stated that the “political leadership” isn’t working on blueprints for a Greek exit, the idea that Greece might be “let go” has captured the imagination of the markets.

A very different view, of the potential damage a Greek exit might cause to the EZ, is expressed by Market Watch – Greek euro exit would be ‘Lehman Brothers squared’: economistquoting Barry Eichengreen, speaking at the American Economic Association conference, who described a Greek exit from the Euro:-

In the short run, it would be Lehman Brothers squared.

Writing at the end of last month the Economist – The euro’s next crisis described the expectation of a Syriza win in the forthcoming elections:-

In its policies Syriza represents, at best, uncertainty and contradiction and at worst reckless populism. On the one hand Mr Tsipras has recanted from his one-time hostility to Greece’s euro membership and toned down his more extravagant promises. Yet, on the other, he still thinks he can tear up the conditions imposed by Greece’s creditors in exchange for two successive bail-outs. His reasoning is partly that the economy is at last recovering and Greece is now running a primary budget surplus (ie, before interest payments); and partly that the rest of the euro zone will simply give in as they have before. On both counts he is being reckless.

In theory a growing economy and a primary surplus may help a country repudiate its debts because it is no longer dependent on capital inflows.

The complexity of the political situation in Greece is such that the outcome of the election, scheduled for 25th January, will, almost certainly, be a coalition. Syriza might form an alliance with the ultra-right wing Golden Dawn who have polled an average of 6.49% in the last 20 opinion polls, who are also anti-Austerity, but they would be uncomfortable bedfellows in most other respects. Another option might be the Communist Party of Greece who have polled 5.8% during the same period. I believe the more important development for the financial markets during the last week has been the change of tone in Germany.

The European bond markets have taken heed, marking down Greek bonds whilst other peripheral countries have seen record low 10 year yields. 10 year Bunds have also marched inexorably upwards. European stock markets, by contrast, have been somewhat rattled by the Euro Break-up spectre’s return to the feast. It may be argued that they are also reacting to concerns about collapsing oil prices, the geo-political stand-off with Russia, the continued slow-down in China and other emerging markets and general expectations of lower global growth. In the last few sessions many stock markets have rallied strongly, mainly on hopes of aggressive ECB intervention.

Unlike the Economist, who are concerned about EZ contagion, Brookings – A Greek Crisis but not a Euro Crisis sees a Euro break-up as a low probability:-

A couple of years ago the prospect of a Syriza-led government caused serious tremors in European markets because of the fear that an extremely bad outcome in Greece was possible, such as its exit from the Euro system, and that this would create contagion effects in Portugal and other weaker nations. Fortunately, Europe is in a much better situation now to withstand problems in Greece and to avoid serious ramifications for other struggling member states. The worst of the crisis is over in the weak nations and the system as a whole is better geared to support those countries if another wave of market fears arise.

It is quite unlikely that Greece will end up falling out of the Euro system and no other outcome would have much of a contagion effect within Europe. Even if Greece did exit the Euro, there is now a strong possibility that the damage could be confined largely to Greece, since no other nation now appears likely to exit, even in a crisis.

Neither Syriza nor the Greek public (according to every poll) wants to pull out of the Euro system and they have massive economic incentives to avoid such an outcome, since the transition would almost certainly plunge Greece back into severe recession, if not outright depression. So, a withdrawal would have to be the result of a series of major miscalculations by Syriza and its European partners. This is not out of the question, but the probability is very low, since there would be multiple decision points at which the two sides could walk back from an impending exit.

I think The Guardian – Angela Merkel issues New Year’s warning over rightwing Pegida group – provides an insight into the subtle change in Germany’s stance:-

German chancellor Angela Merkel in a New Year’s address deplored the rise of a rightwing populist movement, saying its leaders have “prejudice, coldness, even hatred in their hearts”.

In her strongest comments yet on the so-called Patriotic Europeans Against the Islamisation of the West (Pegida), she spoke of demonstrators shouting “we are the people”, co-opting a slogan from the rallies that led up to the fall of the Berlin Wall 25 years ago.

“But what they really mean is: you are not one of us, because of your skin colour or your religion,” Merkel said, according to a pre-released copy of a televised speech she was to due to deliver to the nation on Wednesday evening.

“So I say to all those who go to such demonstrations: do not follow those who have called the rallies. Because all too often they have prejudice, coldness, even hatred in their hearts.”

Concern about domestic politics in Germany and rising support for the ultra right-wing Pegida party makes the prospect of allowing Greece to leave the Euro look like the lesser of two evils. Yet a Greek exit and default on its Euro denominated obligations would destabilise the European banking system leading to a spate of deleveraging across the continent. In order to avert this outcome, German law makers have already begun to soften their “hard-line” approach, extending the olive branch of a potential renegotiation of the terms and maturity of outstanding Greek debt with whoever wins the forthcoming election. I envisage a combination of debt forgiveness, maturity extension and restructuring of interest payments – perish the thought that there be a sovereign default.

Carry Concern

Last month the BIS – Financial stability risks: old and new caused alarm when it estimated non-domestic US$ denominated debt of non-banks to be in the region of $9trln:-

Total outstanding US dollar-denominated debt of non-banks located outside the United States now stands at more than $9 trillion, having grown from $6 trillion at the beginning of 2010. The largest increase has been in corporate bonds issued by emerging market firms responding to the surge in demand by yield-hungry fixed income investors.

Within the EZ the quest for yield has been no less rabid, added to which, risk models assume zero currency risk for EZ financial institutions that hold obligations issued in Euro’s. The preferred trade for many European banks has been to purchase their domestic sovereign bonds because of the low capital requirements under Basel II. Allowing banks to borrow short and lend long has been tacit government policy for alleviating bank balance sheet shortfalls, globally, in every crisis since the great moderation, if not before. The recent rise in Greek bond yields is therefore a concern.

An additional concern is that the Greek government bond yield curve has inverted dramatically in the past month. The three year yields have risen most precipitously. This is a problem for banks which borrowed in the medium maturity range in order to lend longer. Fortunately most banks borrow at very much shorter maturity, nonetheless the curve inversion represents a red flag : –

Date 3yr 10yr Yield curve
14-Oct 4.31 7.05 2.74
29-Dec 10.14 8.48 -1.66
06-Jan 13.81 9.7 -4.11



Over the same period Portuguese government bonds have, so far, experienced little contagion:-

Date 3yr 10yr Yield curve
14-Oct 1.03 2.56 1.53
29-Dec 1.06 2.75 1.69
06-Jan 0.92 2.56 1.64



EZ Contagion

Greece received Euro 245bln in bail-outs from the Troika; if they should default, the remaining EZ 17 governments will have to pick up the cost. Here is the breakdown of state guarantees under the European Financial Stability Facility:-


Country Guarantee Commitments Eur Mlns Percentage
Austria 21,639.19 2.78%
Belgium 27,031.99 3.47%
Cyprus 1,525.68 0.20%
Estonia 1,994.86 0.26%
Finland 13,974.03 1.79%
France 158,487.53 20.32%
Germany 211,045.90 27.06%
Greece 21,897.74 2.81%
Ireland 12,378.15 1.59%
Italy 139,267.81 17.86%
Luxembourg 1,946.94 0.25%
Malta 704.33 0.09%
Netherlands 44,446.32 5.70%
Portugal 19,507.26 2.50%
Slovakia 7,727.57 0.99%
Slovenia 3,664.30 0.47%
Spain 92,543.56 11.87%
EZ 17 779,783.14 100%

Assuming the worst case scenario of a complete default – which seems unlikely even given the par less state of Greek finances – this would put Italy on the hook for Eur 43bln, Spain for Eur 28.5bln, Portugal for Eur 6bln and Ireland for Eur 3.8bln.

The major European Financial Institutions may have learned their lesson, about over-investing in the highest yielding sovereign bonds, during the 2010/2011 crisis – according to an FTinterview with JP Morgan Cazenove, exposure is “limited” – but domestic Greek banks are exposed. The interconnectedness of European bank exposures are still difficult to gauge due to the lack of a full “Banking Union”. Added to which, where will these cash-strapped governments find the money needed to meet this magnitude of shortfall?

The ECBs response

ECB Balance Sheet - Bloomberg

Source: Bloomberg

In an interview with Handelsblatt last week, ECB president Mario Draghi reiterated the bank’s commitment to expand their balance sheet from Eur2 trln to Eur3 trln if conditions require it. Given that Eurostat published a flash estimate of Euro area inflation for December this week at -0.2% vs +0.3% in November, I expect the ECB to find conditions requiring a balance sheet expansion sooner rather than later. Reuters – ECB considering three approaches to QE – quotes the Dutch newspaper Het Financieele Dagbad expecting one of three actions:-

…one option officials are considering is to pump liquidity into the financial system by having the ECB itself buy government bonds in a quantity proportionate to the given member state’s shareholding in the central bank.

A second option is for the ECB to buy only triple-A rated government bonds, driving their yields down to zero or into negative territory. The hope is that this would push investors into buying riskier sovereign and corporate debt.

The third option is similar to the first, but national central banks would do the buying, meaning that the risk would “in principle” remain with the country in question, the paper said.

The issue of “monetary financing” – forbidden under Article 123 of the Lisbon Treaty – has still to be resolved, so Outright Monetary Transactions (OMT) in respect of EZ government bonds are still not a viable policy option. That leaves Covered bonds – a market of Eur 2.6trln of which only around Eur 600bln are eligible for the ECB to purchase – and Asset Backed Securities (ABS) with around Eur 400bln of eligible securities. These markets are simply not sufficiently liquid for the ECB to expand its balance sheet by Eur 1trln. In 2009 they managed to purchase Eur 60bln of Covered bonds but only succeeded in purchasing Eur 16.9bln of the second tranche – the bank had committed to purchase up to Eur 40bln.

Since its inception in July 2009 the ECB have purchased just shy of Eur 108bln of Covered bonds and ABS: –

Security Primary Secondary Total Eur Mlns Inception Date
ABS N/A N/A 1,744 21/11/2014
Covered Bonds 1 N/A N/A 28,817 02/07/2009 *
Covered Bonds 2 6015 10375 16,390 03/11/2011
Covered Bonds 3 5245 24387 29,632 20/10/2014
Total 76,583
* Original purchase Eur 60bln

Source: ECB

These amounts are a drop in the ocean. If the ECB is not permitted to purchase government bonds what other options does it have? I believe the alternative is to follow the lead set by the Bank of Japan (BoJ) in purchasing corporate bonds and common stocks. To date the BoJ has only indulged in relatively minor “qualitative” easing; the ECB has an opportunity to by-pass the fragmented European banking system and provide finance and permanent capital directly to the European corporate sector.

Over the past year German stocks has been relatively stable whilst Greek equities, since the end of Q2, have declined. Assuming Greece does not vote to leave the Euro, Greek and other peripheral European stocks will benefit if the ECB should embark on its own brand of Qualitative and Quantitative Easing (QQE):-

Athens_vs_DAX_one_year bloomberg

Source: Bloomberg               Note:      Blue = Athens SE Composite               Purple = DAX

It is important to make a caveat at this juncture. The qualitative component of the BoJ QQE programme has been derisory in comparison to their buying of JGBs; added to which, whilst the socialisation of the European corporate sector is hardly political anathema to many European politicians it is a long way from “lending at a penal rate in exchange for good collateral” – the traditional function of a central bank in times of crisis.

Conclusion and investment opportunities

European Government Bonds

Whilst the most likely political outcome is a relaxation of Article 123 of the Lisbon Treaty, allowing the ECB, or the national Central Bank’s to purchase EZ sovereign bonds, much of the favourable impact on government bond yields is already reflected in the price. 10 year JGBs – after decades of BoJ buying – yield 30bp, German Bunds – without the support of the ECB – yield 46bp. Aside from Greek bonds, peripheral members of the EZ have seen their bond yields decline over the past month. If the ECB announce OMT I believe the bond rally will be short-lived.

European Stocks

Given the high correlation between stocks markets in general and developed country stock markets in particular, it is dangerous to view Europe in isolation. The US market is struggling with a rising US$ and collapsing oil price. These factors have undermined confidence in the short-term. The US market is also looking to the Europe, since a further slowdown in Europe, combined with weakness in emerging markets act as a drag on US growth prospects. On a relative value basis European stocks are moderately expensive. The driver of performance, as it has been since 2008, will be central bank policy. A 50% increase in the size of the ECB balance sheet will be supportive for European stocks, as I have mentioned in previous posts, Ireland is my preferred investment, with a bias towards the real-estate sector.

The Euro

Whilst the EUR/USD rate continues to decline the Nominal Effective Exchange Rate as calculated by the ECB, currently at 98, is around the middle of its range (81 – 114) since the inception of the currency and still some way above the recent lows seen in July 2012 when it reached 94. The October 2000 low of 81 is far away.

If a currency war is about to break-out between the major trading nations, the Euro doesn’t look like the principal culprit. I expect the Euro to continue to decline, except, perhaps against the JPY. Against the GBP a short EUR exposure will be less volatile but it will exhibit a more political dimension since the UK is a natural safe haven when an EZ crisis is brewing.


The present monetary system the key cause for boom-bust cycles

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.


Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. In a free-market economy, a bank that over-issues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will fall. To protect their purchasing power, holders of the over-issued certificates naturally attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. On this Mises wrote,


People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”1

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.
The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentive to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank-i.e., a central bank-that manages the expansion of paper money.
To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. In short, the central bank paper certificates are fully backed by banks certificates, which have the historical link to gold.)


The central bank paper money, which is declared as the legal tender, also serves as a reserve asset for banks. This enables the central bank to set a limit on the credit expansion by the banking system. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out. In short, by means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.
It would appear that the central bank can manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other. This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system.

Observe that while, in the free market, people will not accept a commodity as money if its purchasing power is subject to a persistent decline, in the present environment, central authorities are coercively imposing money that suffers from a steady decline in its purchasing power. Since the present monetary system is fundamentally unstable it is not possible to fix it. Even Milton Friedman’s scheme to fix the money rate growth at a given percentage won’t do the trick. After all a fixed percentage growth is still money growth, which leads to the exchange of nothing for something-i.e., economic impoverishment and the boom-bust cycle. Moreover, we can conclude that there cannot be a “correct” money supply rate of growth. Whether the central bank injects money in accordance with economic activity or fixes the rate of growth, it further destabilizes the economy.


The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding. Once the pool begins to stagnate-or, worse, shrinks then no monetary pumping will be able to prevent the plunge of the system. A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles. In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan has originated out of nothing, it obviously couldn’t have had an owner. In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.


1.  Mises , Human Action p 446.