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.
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.
2014 ended with two ominous developments: the strength of the US dollar and a collapse in key commodity prices.
It is tempting to view both events as one, but the continuing fall in oil prices through December reveals they are sequential: first there was a greater preference for dollars compared with other currencies and this still persists, followed by a developing preference for all but the weakest currencies at the expense of raw materials and energy. These are two steps on a path that should logically lead to a global slump.
Dollar strength was the first warning that things were amiss, leading to higher interest rates in many of the emerging economies as their central banks sought to control investment outflows. Since this followed a prolonged period of credit expansion these countries appear to be entering the bust phase of the credit-driven boom-and-bust cycle; so for them, 2015 at a minimum will see a slump in economic activity as the accumulated malinvestments from the past are unwound. According to the IMF database, emerging market and developing economies at current prices account for total GDP of over $30 trillion, compared with advanced economies’ GDP totalling $47 trillion. It is clear that a slump in the former will have serious repercussions for the latter.
As the reserve currency the dollar is central to the exchange value of all other currencies. This is despite attempts by China and Russia to trade without it. Furthermore and because of this dependency, the global economy has become more geared to the dollar over the years because it has expanded relative to the US. In 2000, the US was one-third of global GDP; today it is about one-fifth.
The second development, falling energy and commodity prices, while initially driven by the same factors as dollar strength, confirms the growing likelihood of a global slump. If falling prices were entirely due to increased supply of the commodities involved, we could rejoice. However, while there has been some increase in energy and commodity supply the message is clear, and that is demand at current prices has unexpectedly declined, and prices are now trying to find a new equilibrium. And because we are considering world demand, this development is being missed or misread by economists who lack a global perspective.
The price of oil has approximately halved in the last six months. The fall has been attributed variously to the west trying to bankrupt Russia, or to Saudi Arabia driving American shale production out of business. This misses the bigger picture: according to BP’s Statistical Review 2014, at the beginning of last year world oil consumption comfortably exceeded supply, 91.3million barrels per day compared with 86.8. This indicates that something fundamental changed in 2014 to collapse the price, and that something can only be a sudden fall in demand in the second half.
Iron ore prices have also halved over the last six months, but other key commodities, such as copper which fell by only 11% over the period, appear to have not yet adjusted to the emerging markets slump. This complies with business cycle theory, because in the early stages of a slump businesses remain committed to their capital investment plans in the vain hope that conditions will improve. This being the case, the collapse in demand for energy can be expected to deepen and spread to other industrial raw materials as manufacturers throw in the towel and their investment plans are finally abandoned.
Therefore the economic background to the financial outlook for the global economy is not encouraging. Nor was it at the beginning of 2014, when it was obviously going to be a difficult year. The difference a year on is that the concerns about the future are more crystallised. This time last year I wrote that we were heading towards a second (to Lehman) and unexpected financial and currency crisis that could happen at any time. I only modify that to say the crisis has indeed begun and it has much further to go this year. This is the background against which we must briefly consider some of the other major currencies, and precious metals.
Japan and the yen
The complacency about Japan in the economic and investment communities is astonishing. Japan is committed to a scale of monetary inflation that if continued can only end up destroying the yen. The Bank of Japan is now financing the equivalent of twice the government deficit (¥41 trillion) by issuing new currency, some of which is being used to buy Japanese equity ETFs and property REITs. By these means pricing in bond, equity and commercial property markets has become irrelevant. “Abenomics” is about financing the government and managing the markets under the Keynesian cover of stimulating both the economy and animal spirits. In fact, with over ¥1.2 quadrillion of public sector debt the government is caught in a debt trap from which it sees no escape other than bluff. And since Abenomics was first embarked upon two years ago, the yen has fallen from 75 to the US dollar to 120, or 37%.
Instead of learning the lessons of previous hyperinflations, mainstream economists fall for the official line and ignore the facts. The facts are simple: Japan is a welfare state with an increasing and unsustainable ratio of retirees to tax-paying workers. She is the leading advanced nation on a debt path the other welfare nations are closely following. Consensus forecasts that the Japanese economy will be stimulated into recovery in 2015 are wide of the mark: instead she is destroying her currency and private sector wealth with it.
Eurozone and the euro
In the short-term the Eurozone is being revisited by its Greek problem. Whether or not the next Greek government backs off from confronting the other Eurozone members and the ECB remains to be seen. The problems for the Eurozone lie considerably deeper than Greece, made worse by politicians who have been reluctant to use the time bought by the ECB to address the structural difficulties of the 19 Eurozone members. The result is the stronger northern bloc (Germany, Netherlands, Finland and Luxembourg) is being crippled by the burden of the Mediterranean states plus Portugal plus France. And Germany and Finland have suffered the further blow of losing valuable export business from Russia.
In the coming months the Eurozone will likely face gas shortages from Russia through the trans-Ukrainian pipeline, and price deflation driven by energy and other commodity prices. Price deflation spurs two further points to consider, one false and the other true: lower prices are deemed to be recessionary (false), and falling prices increase the burden of real debt (true). The consequence is that the ECB will seek ways to expand money supply aggressively to stop the Eurozone from drifting into an economic crisis. In short, the Eurozone will likely develop its own version of Abenomics, the principal difference being the Eurozone’s timeline is behind Japan’s.
US and UK
Japan and the Eurozone account for total GDP of $18.3 trillion, slightly more than the US and added to the emerging and developing economies, gives a total of $48 trillion, or 62% of global GDP for nations leading the world into a slump. So when we consider the prospects for the US and the UK, together producing $20.4 trillion or 26% of the world’s GDP, their prospects are not good either. The UK as a trading nation exposed to the Eurozone has immediate risk, while the US which is not so dependent on international trade, less so.
The foregoing analysis is of the primary economic drivers for 2015 upon which all else will ultimately depend. The risk of a global slump can be called a first order event, while the possibility of a banking crisis, derivatives default or other market dislocation brought on by a slump could be termed a second order event. There is no point in speculating about the possibility and timing of second order events occurring in 2015, because they ultimately depend on the performance of the global economy.
However, when it becomes clear to investors that the global economy is indeed entering a slump, financial and systemic risks are certain to escalate. Judging this escalation by monitoring markets will be difficult because central banks, exchange stability funds and sovereign wealth funds routinely intervene in markets, rendering them misleading as price signals.
Precious metals are the only assets beyond the long-term control of governments. They can distort precious metal markets in the short term by expanding the quantity of derivatives, and there is a body of evidence that these methods have been employed in recent years. But most price distortion today appears to have come from bullion and investment banks who are fully committed to partying in bonds, equities and derivatives, and for which gold is a spoiler. This complacency is bound to be undermined at some point, and a global economic slump is the likely catalyst.
The dangers of ever-inflating currencies are clearly illustrated by the Fiat Money Quantity, which has continued to expand at an alarming rate as shown in the chart below.
FMQ measures the amount of fiat currency issued as a replacement for gold as money, so is a measure of unbacked monetary expansion. At $13.52 trillion last November it is $5.68 trillion above the long-established pre-Lehman crisis growth path, stark evidence of a depreciating currency in monetary terms. Adjusting the price of gold for this depreciation gives a price today the equivalent of $490 in dollars at that time and quantity, so gold has roughly halved in real currency terms since the Lehman crisis.
There is compelling evidence that 2015 will see a global slump in economic activity. This being the case, financial and systemic risks will increase as evidence of the slump accumulates. It can be expected to undermine global equities, property and finally bond markets, which are currently all priced for economic stability. Even though these markets are increasingly controlled by central bank intervention, it is dangerous to assume this will continue to be the case as financial and systemic risks accumulate.
Precious metals are ultimately free from price management by the state. Furthermore, they are the only asset class notably under-priced today, given the enormous increase in the quantity of fiat money since the Lehman crisis.
In short, 2015 is shaping up to be very bad for fiat currencies and very good for gold and silver.
Recent dollar strength has been a surprise to many but a strong dollar was also a key component of the Asian currency crises of 1997-98. These contributed to sharply lower oil prices, which in turn helped to trigger the 1998 Russian debt default, European bond spread de-convergence and spectacular blowup of hedge-fund Long Term Capital Management (LTCM). It is worth recalling that, when LTCM failed, the dollar abruptly gave up a full year of gains. While history rhymes rather than repeats, I suspect something comparable is likely in 2015, although with US total economy debt much higher, the potential for a sharp decline in the dollar is that much greater.
Back when I managed macro strategy teams at investment banks, I had a simple set of guidelines that I required junior strategists to follow when making investment recommendations, that is, in addition to those required by the firm or the regulators. These included:
- Recommendations must be supported by a broad range of fact-checked evidence, rather than one or two ‘cherry-picked’ pieces;
- Recommendations must be ‘actionable’ in a practical way by the target clients and one or more of these must be specified;
- Recommendations must not only provide a specific price (or return) target, but also an estimate of risk (or volatility) and reference to a specific time horizon;
- Recommendations must include one or more conditions under which the particular investment would no longer be as attractive, if at all.
In practice, most analysts managed in their initial draft recommendations to follow the first two but struggled when it came to the third and fourth. The reason for this is most probably the inclination that many if not all quantitative-analytical types have for expecting that financial assets be priced ‘correctly’, according to whatever analytical framework is applied. If something is out of line, so the thinking goes, it should start correcting as soon as the analysis in question is complete and should completely correct over the short-to-medium term time horizon of primary importance to the bulk of those active in the investment management industry.
While that might seem reasonable, the problem is that, notwithstanding claims to the contrary, investors are not rational. Indeed, I would hold that no economic actors are rational in any meaningful, measurable way. This is due in part to my view of human nature and modern psychology seems to uncover new ways in which our minds are biased and irrational with each passing day. But if all investment opinions are biased and irrational to some degree, the sum of all such opinions—the financial markets—is most probably also biased and irrational.
So-called ‘behavioural investing’ tries to address these biases in a systematic way in order generate excess investment returns over time with acceptably low risk. However, the problem with any such ‘fight the irrational herd’ approach is, to paraphrase Keynes, “The herd can remain irrational longer than the rational investor can remain solvent.” On top of this there is the added complexity of the so-called ‘beauty contest’, also mentioned by Keynes, in which investors constantly try to out-guess each others’ intentions, irrational, behavioural or otherwise, so what in fact is ultimately decisive in price determination at any point in time arguably has little if anything to do with any underlying, fundamental, rational investment process.
Having been an active investor for many years, I have experienced a number of profit and loss events across a broad range of assets and strategies. In the end, while idea generation, however rudimentary, is necessary to active trading or investing, it is ultimately some aspect of risk management, of knowing when NOT to trade or invest, that often tips the balance between success and failure. Sure, anyone can be ‘smart’ or ‘lucky’ for a time but the irrational herd is far more dangerous to the unusually smart than to the lucky, even though many in the latter category no doubt consider themselves also (or perhaps exclusively) in the former camp.
The fight against irrationality, if one wishes to call it that, is thus one that is overwhelming more likely to be won in the longer-term, over which most investors have only little or no interest. In the economic jargon, investors have high ‘time preference’ to front-load investment returns, by implication taking irrationally large longer-term risks. For institutional investors managing other peoples’ money, it is often a losing business proposition to fight the herd so aggressively as to risk losing clients, even if the investment views implemented ultimately work out longer-term. Holding on to client money month after month, quarter after quarter, year after year, when an apparently irrational market chooses to become ever more irrational is a potentially career-limiting move in the extreme. Thus herd-following, rather than fighting, becomes the industry norm, and those who rise to the top of large asset management organisations do so not because they are great investors but because they are skilled at retaining client assets regardless of the direction in which the irrational herd is travelling.
This natural (if irrational) herding tendency is further exaggerated when economic or monetary officials intervene in order to ‘stabilise’ asset markets, which at least since 1987 has meant to prevent them from correcting violently to the downside. 1. When the herd believes that officials have their backs, they tend to ignore the risks closing in on their backsides for far longer than they ought to. And so the inevitable bubbles that form can continue to grow and grow, yet concern about them fades and fades, as normalcy bias and policy goals converge in a world of ever-rising or at least not falling asset prices.
In this world, biased by policy towards steadily rising asset prices, returns beget leverage, and leveraged returns beget greater leverage. Regulators pretend as if they can manage this and its probable future effects on the financial system and economy, but 2008 and many other manias, panics and crashes that have come and gone before inform us otherwise. Sure, a new regulatory effort is rolled out now and again, to much fanfare: Note the central bankers’ ‘macroprudential’ PR campaign over the past two years. The ivory-tower academic folk who originally propose such measures—or so they claim—applaud on the sidelines while taking implied, self-serving credit. (These academics are equally quick to blame the ‘private sector’ whenever anything goes wrong, as their ideas can’t possibly be at fault.)
I’ve been around long enough to see this dynamic play out on multiple occasions. I also witnessed first-hand the spectacular events of 1997-98, a period with strong parallels to today. Back then, the dollar rose on the false view that the US could decouple from crises abroad. When events abruptly proved otherwise, the dollar gave up a full year’s gains in just two weeks. The same could happen in 2015.
POOR-QUALITY GROWTH, RISING IMBALANCES
Following six years of zero interest rates and QE, the US economy has still failed to resume healthy, sustainable growth. Yes, the economy is growing at present and there have been some pockets of deleveraging. But this amounts to ‘cherry picking’ the range of available evidence and thus fails to adhere to even the first of my guidelines for investment recommendations. Looking behind the numbers in more detail, as I prefer to do, one sees an unbalanced economy that is re-leveraging amid the growth of yet another asset bubble.
Now my mainstream economic critics will scoff at this, pointing to the recently-released Q3 GDP report, for example, as demonstrating that healthy US growth has resumed. But when you look behind the numbers at the composition, the quality of the growth, it remains poor. One way to do this is to strip out the volatile inventory cycle and see what remains of ‘core’ GDP growth, referred to as ‘real final sales’. US real final sales growth has been positive over the past few years but, notwithstanding massive policy stimulus, has barely managed to rise above 2% year-over-year. Past recoveries have seen rates two to three times higher.
‘CORE’ GDP GROWTH STUCK AROUND 2% Y/Y
If you go one step further and strip out population growth, what remains is a per-capita core growth rate of little more than zero. And what has it taken to achieve this near zero rate of per-capita growth? Why, huge government deficits which have not been spent on long-term infrastructure investment but rather programmes designed to promote current consumption. Moreover, households have been re-leveraging following a period of sharp retrenchment in 2008-9. The savings rate, averaging about 4.5% over the past few years, is only marginally higher than it was in the bubble years of 2004-7.
HOUSEHOLD LEVERAGE HAS SOARED AGAIN…
…AS THE SAVINGS RATE HAS DECLINED ANEW
There was some material deleveraging of corporate balance sheets in 2009-12 but that has now given way to re-leveraging. Much of this is occurring via share buy-backs, which were all the rage in 2014, perhaps because without them, earnings per share would not have risen by much, if at all, given now-negative US corporate profit growth.
Now this may be the first you have heard about ‘negative’ US corporate profit growth. But if you look at profits not in the ‘pro-forma’ way that corporations present them to shareholders but in how they actually report them for official pourposes according to the methodology used in the national accounts, this is precisely what you see.
CORPORATE PROFIT GROWTH NOW NEGATIVE
This is not to say that the huge monetary and fiscal stimulus in the wake of the GFC had no effect. No, it had a huge effect. But that effect was primarily to bring future consumption artificially forward and thereby to reduce the savings available to provide for investment and future consumption. Eminent Austrian Economist Ludwig von Mises famously claimed that this was akin to “burning the furniture to heat the home.” (The pernicious effects of capital consumption are discussed in greater detail here.)
The fact is that the US is not saving enough to provide for current much less future consumption and thus must continue to borrow from the rest of the world. While the US trade deficit is not as large today as it was back in the bubble years of 2004-7—in large part due to increased domestic energy production—it remains sizeable in a historical comparison and, of course, adds to the enormous cumulative deficit that already exists.
US STILL DEPENDENT ON FOREIGN CAPITAL
So not only is US growth not on a sustainable path; to the extent there is growth, much of it is being financed with US-issued IOUs (ie dollars). The dollar may be strong at present due to flows out of various underperforming emerging markets. But this should not disguise the fact that the US economy cannot possibly decouple from the rest of the world when it is in fact highly dependent on the rest of the world as a source of financing.
DECLINING OIL PRICES ARE A KEY MECHANISM OF AN INEVITABLE RECOUPLING
Much us external financing is in the form of recycled ‘petrodollars’ from the larger oil-exporting countries such as Saudi Arabia, who take oil revenues and invest them in US assets such as Treasury bonds. This has two inter-related effects, supporting demand for the US dollar and helping to hold down US interest rates. As oil prices decline, however, so do oil revenues, in particular if global demand is declining, as it appears to be doing. This implies less recycling of petrodollars.
While in theory declining oil prices are supportive of growth, this is true only to the point that the financial system is not leveraged to oil revenues. Russia’s 1998 default on its external debt is a classic case in point. All of a sudden what appeared a benign development for the US economy was anything but, as through various financial linkages, the US financial system was in fact exposed to a sharp decline in global oil revenues.
Global liquidity, sloshing as it does from place to place, is much like the tides of the oceans. Local observers in different locations might not notice or care that a high tide in one place implies a low tide in another. But the global observer knows better: An extreme high tide in one part of the world will correspond to an extreme low tide elsewhere. But these need not occur simultaneously, as the flow from high to low between locations can take time.
Collapsing oil revenues were the proximate trigger for Russia’s 1998 decision to default on its external debt. European banks were among Russia’s primary creditors and thus they had to liquidate holdings of peripheral EU debt in order to raise capital. This pushed peripheral bond spreads sharply wider, reversing the trend in leveraged euro ‘convergence trades’ in the run-up to European monetary union. LTCM was one of the largest, most highly-leveraged followers of this strategy and found it suddenly faced huge losses potentially exceeding its capital. LTCMs creditors—primarily bulge-bracket Wall Street banks—demanded additional collateral be posted immediately. But there wasn’t enough high-quality collateral to go around and so the price of the highest-quality collateral—US Treasury bonds—soared to records in the scramble.
The Fed soon realised the scale of the potential danger: A default cascading through the heart of Wall Street. It thus placed pressure on all LTCM’s creditors to agree to a plan to ease off on collateral calls, allowing for an orderly unwind of positions. In return, the Fed would lower interest rates, to the benefit of all participants.
While these actions succeeded in containing the damage, they signalled to the world that the US financial system was in fact highly leveraged to the international financial markets and thus exposed indirectly to the serial crises elsewhere. Moreover, the Fed was willing to lower interest rates as required to bail out the US financial system. Hence the dollar was not the safe-haven it was previously thought to be and suddenly plunged in value, wiping out an entire year’s gains in a violent, two-week selloff.
A YEAR’S DOLLAR GAINS ERASED IN WEEKS
The US stock market also took notice, falling sharply as the re-coupling of the US to global reality set in. It was not until the Fed announced the LTCM bail out and rate cuts that the stock market began to recover.
Over the next two years, it did more than merely recover. With Fed policy actions having stimulated aggressive herd buying of equities, the NASDAQ crack-up boom took place, followed by the inevitable bust of 2001-03.
…AND A MAJOR STOCK MARKET CORRECTION
DE-CONVERGENCE HAS RUN A LONG WAY; RE-CONVERGENCE COULD OCCUR AT ANY TIME
The parallels with 1997-98 are increasingly clear. Currencies, asset markets and growth have slumped across Asia and Europe, yet US financial markets have been largely unaffected, happily continuing to climb. The dollar has strengthened steadily. Yet in the sharp decline in oil and other commodity prices we see a mechanism in motion that, in some way yet unseen, will eventually choke off the flow of liquidity into US financial markets. While I don’t anticipate that Russia will default this time round—Russia’s external government debt is tiny—there are a number of other countries out there highly dependent on commodity exports for external debt service.
Indonesia and Malaysia are two cases in point, the former being a relatively large emerging market economy. Sharp weakness in these countries’ currencies of late is an indication of growing stress eerily similar to 1997. Either or both of these countries could soon find they are unable to prevent large withdrawals of foreign capital. But devaluing a currency to deal with a balance-of-payments crisis doesn’t work as the problem is external debt denominated in a foreign currency, in this case dollars. The International Monetary Fund might try to come to the rescue, as it did in 1997-98, but the scale of the problem is far larger this time round.
Also worth mentioning here is something rather closer to home. The US shale industry is hugely dependent on leveraged financing from the US banking and shadow banking systems. (The latter uses structured financing vehicles of various kinds. By some estimates as much as a quarter of the entire US high yield debt market is related to the shale industry in some way.) With crude oil prices now plunging below $50/bbl, a huge portion of shale oil production has become unprofitable. Yet with debt to service, producers have no choice but to continue producing as much oil as they can. This will help to keep a lid on prices but will also bleed the most poorly financed producers to the point of insolvency and default, with potentially grave implications for the US financial system. (Some readers may recall the Texas oil, property and savings and loan collapse of the late 1980s, a key contributor to the eventual federal bail out of the entire US savings and loan industry.)
There are thus several ways in which today’s commodity price bust could turn into a more general financial crisis, as in 1997-98. It is impossible to know. But in my opinion, unless commodity prices soon recover, it is only a matter of time before a wave of balance-of-payment crises and/or corporate insolvences begin to dissolve the pillars of sand on which the strong dollar currently stands.
STRATEGIES FOR A DOLLAR REVERSAL
Those investors who agree that dollar strength is likely to reverse, perhaps abruptly, in 2015, should consider now those strategies that will perform well in that sort of environment.
There are various ways to speculate on a weaker dollar, the most straightforward of which is to short the dollar against other currencies in the foreign exchange markets. The difficultly with this, however, is that investors then need to take a view regarding which currencies are most likely to re-strengthen versus the dollar. Given that many countries would oppose currency strength at present, investors should take care. A diversified approach is probably best, and there are various vehicles that exist for this purpose, including the Merk currency funds. (Disclosure: Axel Merk is a personal friend I have known for many years. However I have no financial interest in his funds, nor do I receive commissions or compensation of any sort for recommending them.)
However, given that many countries might resist currency strength, the case can be made that gold has more upside potential in a dollar reversal. Moreover, if the environment turns decidedly risk-averse, as it did in 1998 for example, gold can benefit two-fold. Last year, Axel Merk launched the Merk Gold Trust (NYSE: OUNZ), a vehicle that allows for investors to take physical delivery of their gold, if desired, without this qualifying as a taxable event.
Gold’s poor sister silver is arguably better value at present, although in a risk-off environment it would be normal for gold to outperform silver. A simple diversification compromise would be to allocate 2/3 to gold and 1/3 to silver. This is because silver is normally about twice as volatile as gold. From a risk perspective, this implies an equal risk weighting in each of these two monetary metals. There are ETFs available that can be rebalanced periodically to keep holdings from drifting too far from the target 2/3 and 1/3 allocations.
Finally, a quick word on oil. While I have written above about the potentially negative financial market consequences of the recent, sharp decline in oil prices, there is of course much underlying demand for oil that is not particularly cyclical in nature but will occur even in a weak or zero-growth environment. Here I note that, even in the depths of the 2008 crisis, the oil price (WTI) found support around $40/bbl before recovering. At just under $50/bbl at time of writing, that is still a 20% decline from here, but the eventual upside recovery potential is probably far greater than 20%. For investors willing to take a risk amid what admittedly appears to be a ‘blood on the streets’ environment for oil at present, I’d recommend building a position here, either through an ETF or just by buying shares of upstream oil producers.
In relative terms, oil looks even better value, for example relative to industrial metals such as copper or aluminium. Yes, the latter have also seen prices come off but not to anywhere near the same extent. Platinum group metals may be precious but they are used overwhelmingly in industrial applications, in particular autocatalysts, and in the event that automobile demand should slow, there is much potential for these to decline relative to the price of oil. Palladium is considerably more exposed than platinum to this scenario and is thus the better short.
The really brave might even take a look at the debt of distressed shale producers, although I have no particular expertise in that area. A distressed industry is one that will likely be restructured in some way, such as by private equity firms swooping in, taking viable companies private, and restructuring them for the longer-term, out of the public spotlight.
1. There is in fact a far longer history of such interventions. In the US these include the devaluation of the US dollar by executive fiat in 1934 and abrogation of Bretton-Woods treaty obligations in 1971.
“Sir, John Authers, in Loser’s Game (The Big Read, December 22), could have delved deeply into the flaws in the asset management business as it has evolved in recent decades, rather than accepting the industry’s own terms or focusing on tweaks to “active” management that might improve results..
“Mr Authers could also have challenged the bureaucratic thinking and methods asset management has adopted in the course of chasing its “bogeys”, starting with the Big Ideas.. Then there are the model portfolios, relative-weightings, “style drift”, investment committees, the requirement to be fully invested and so on — all bog down decision-making and most have nothing to do with genuine investing. In adopting these practices the fund management business has created a recipe for mediocrity.
“In investing, it is never a good idea to do what everyone else is doing. Piling into passive index funds during a year of decidedly poor relative results for active managers, and especially after a long period of rising security prices is likely to lead to future disappointment, just as it did in 1999. This leads us to another line of inquiry for Mr Authers: even assuming “beating” an index is worthwhile, why must we do it all of the time? It is a paradox of investment that in order to do well in the long run, you sometimes have to do “poorly” in the short run. You have to accept the fact that often you will not “beat” an index; sometimes you don’t even want to — think of the Nasdaq in 1999, for example..”
– Letter to the FT from Mr. Dennis Butler, December 30, 2014.
A happy new year to all readers.
For historians, there are primary sources and secondary sources. Primary sources are the original documents that point to the raw history, like the original Magna Carta, for example. Secondary sources are effectively historical derivatives – they incorporate interpretation and analysis. In financial markets, the equivalent of primary sources are prices – the only raw data that speak unequivocally of what occurred by way of financial exchange between buyer and seller. Everything else amounts to interpretation and analysis, and must by definition be regarded as subjective. So-called fundamentals, therefore, are subjective. There is the price – and everything else is essentially chatter.
It says much for the quality and depth of our mainstream media that one of the most insightful and thought-provoking pieces of social and cultural analysis of the last year came in the form of a 5 minute essay within a satirical news review of 2014. The piece in question was by the cult documentary maker Adam Curtis and you can watch it here. The following extracts are taken directly from the film:
“So much of the news this year has been hopeless, depressing, and above all, confusing. To which the only response is to say, “oh dear.”
“What this film is going to suggest is that that defeatist response has become a central part of a new system of political control. And to understand how this is happening, you have to look to Russia, to a man called Vladislav Surkov, who is a hero of our time.
“Surkov is one of President Putin’s advisers, and has helped him maintain his power for 15 years, but he has done it in a very new way.
“He came originally from the avant-garde art world, and those who have studied his career, say that what Surkov has done, is to import ideas from conceptual art into the very heart of politics.
“His aim is to undermine people’s perceptions of the world, so they never know what is really happening.
“Surkov turned Russian politics into a bewildering, constantly changing piece of theatre. He sponsored all kinds of groups, from neo-Nazi skinheads to liberal human rights groups. He even backed parties that were opposed to President Putin.
“But the key thing was, that Surkov then let it be known that this was what he was doing, which meant that no-one was sure what was real or fake. As one journalist put it: “It is a strategy of power that keeps any opposition constantly confused.”
“A ceaseless shape-shifting that is unstoppable because it is undefinable..
“But maybe, we have something similar emerging here in Britain. Everything we’re told by journalists and politicians is confusing and contradictory. Of course, there is no Mr. Surkov in charge, but it is an odd, non-linear world that plays into the hands of those in power.
“British troops have come home from Afghanistan, but nobody seems to know whether it was a victory or whether it was a defeat.
“Ageing disk jockeys are prosecuted for crimes they committed decades ago, while practically no one in the City of London is prosecuted for the endless financial crimes that have been revealed there..
“..the real epicentre of this non-linear world is the economy, and the closest we have to our own shape-shifting post-modern politician is [U.K. Chancellor of the Exchequer] George Osborne.
“He tells us proudly that the economy is growing, but at the same time, wages are going down.
“He says he is reducing the deficit, but then it is revealed that the deficit is going up.
“But the dark heart of this shape-shifting world is Quantitative Easing. The government is insisting on taking billions of Pounds out of the economy through its austerity programme, yet at the very same time it is pumping billions of Pounds into the economy through Quantitative Easing, the equivalent of 24,000 Pounds for every family in Britain.
“But it gets even more confusing, because the Bank of England has admitted that those billions of Pounds are not going where they are supposed to. A vast majority of that money has actually found its way into the hands of the wealthiest five percent in Britain. It has been described as the biggest transfer of wealth to the rich in recent documented history.
“It could be a huge scandal, comparable to the greedy oligarchs in Russia. A ruthless elite, siphoning off billions in public money. But nobody seems to know.
“It sums up the strange mood of our time, where nothing really makes any coherent sense. We live with a constant vaudeville of contradictory stories that makes it impossible for any real opposition to emerge, because they can’t counter it with any coherent narrative of their own.
“And it means that we as individuals become ever more powerless, unable to challenge anything, because we live in a state of confusion and uncertainty. To which the response is: Oh dear. But that is what they want you to say.”
The start of the New Year is traditionally a time for issuing financial forecasts. But there seems little point in doing so given the impact of widespread financial repression on the price mechanism itself. Are prices real, or fake ? The cornerstone of the market structure is the price of money itself – the interest rate. But interest rates aren’t being set by a free market. Policy rates are being kept artificially low by central banks, while the term structure of interest rates has been hopelessly distorted by monetary policy conducted by those same central banks. Inasmuch as ‘real’ investors are participating in the bond market at all, those institutional investors have no personal skin in the game – they are economic agents with no real accountability for their actions. Other institutional players can be confidently assumed simply to be chasing price momentum – they likely have no ‘view’ on valuation, per se. The world’s bond markets have become a giant Potemkin village – nobody actually lives there.
So of the four asset classes to which we allocate, three of them offer at least some protection against the material depradations and endless price distortions of the State. ‘Value’ listed equities give us exposure to the source of all fundamental wealth – the actions of the honest entrepreneur. Systematic trend-following funds are the closest thing we can find to truly uncorrelated investments – and we note how 2014 saw a welcome return to form. The monetary metals, gold and silver, give us Stateless money that cannot be printed on demand by the debt-addicted. We are slowly coming to appreciate the counsel of a friend who suggested that the merit of gold lies not in its price so much as in its ownership. What matters is that you own it. (It also matters why.) Which leaves debt. Objectively high quality debt – a small market and getting smaller by the day.
The practice of sensible investment becomes difficult when our secondary information sources (“fundamentals”) are inherently subjective. It becomes almost impossible when our primary information sources (prices) can’t be trusted because they have politicians’ paw-prints all over them. “Nothing really makes any coherent sense.. We live with a constant vaudeville of contradictory stories.. We live in a state of confusion and uncertainty.” If the pursuit of certainty is absurd, the only rational conclusion is to acknowledge the doubt, and invest accordingly.
There is a significant risk that the financial effects of the collapse in the oil price could spread through the financial system. Already there must have been significant transfers of value through OTC derivative markets, whose gross notional value is about $700 trillion. Roughly $300 trillion of this is with the top US banks as counterparty. A minority of this is with credit default swaps, but if there is problem here, it could easily spread to other derivative categories through counterparty risk.
Remember that the US economy is $17 trillion, so we are talking figures of a far greater magnitude than that.
We have had these scares in the past, notably with AIG, and the Lehman crisis, and also with the Eurozone crisis when Greece, Spain, Portugal and Italy were insolvent together. We could be on the verge of another such crisis, this time triggered by the collapse in the price of crude oil.
For me one event we cannot ignore is a clause slipped into the omnibus finance bill passed by Congress last week, whereby the FDIC, which insures small bank deposits in the event of a bank failure, will also take on responsibility for derivative contracts. The only possible reason this has been slipped in must be because the Wall Street banks are worried about counterparty risk for derivatives, which is totally beyond any individual bank’s control.
The fact that this is the subject of urgent legislation (the wording was put together by Citi and adopted word for word) instead of a more considered approach confirms to me that we have a real problem on our hands.
Parliamentary committees are not especially noted for entertainment, but the November Treasury Select Committee hearing on the Bank of England’s Inflation Report is a refreshing exception. The fun starts on p. 30 of the transcript of the hearings with Steve Baker MP and Bank of England Governor Mark Carney light-heartedly jousting with each other.
Steve begins by asking Dr. Carney if the Bank is all model-driven. To quote from the transcript:
Dr Carney: No. If we were all model driven, then you would not need an MPC.
Q81 Steve Baker: All right. But we do have plenty of models floating around.
Dr Carney: I presume you feel we do need an MPC, Mr Baker?
Steve Baker: I think you know I think we don’t.
Dr Carney: I just thought we would get that read into the record.
[KD: First goal to Dr. Carney, but looks to me like it went into the wrong net.]
Steve Baker: I want to turn to a criticism by Chris Giles in The Financial Times of the model for labour market slack, which called it a nonsense. If I may I will just share a couple of quotes with you. He said that, according to a chart in the inflation report, the average-hours gap hit a standard deviation of -6, and this is something we would expect to happen once in 254 million years. He also said that the Bank of England is again implying the recent recession, as far as labour market participation is concerned, was worse than any moment in 800 times the period in which homo sapiens have walked on the earth. How will the Bank reply to a criticism as strident as this one?
[KD: The article referred to is Chris Giles, “Money Supply: Why the BoE is talking nonsense”, Nov 17 2014: http://ftalphaville.ft.com/2014/11/17/2045002/moneysupply-why-the-boe-is-talking-nonsense/#]
Dr Carney: Since you asked, let me reply objectively. Calculations such as that presume that there is a normal distribution around the equilibrium rate. Let me make it clear. First off, what is the point of the chart? The chart is to show a deviation relative to historic averages. It is an illustrative chart that serves the purpose of showing where the slack is relative to average equilibrium rates, just to give a sense of relative degrees of slack. That is the first point. The second point is that the calculation erroneously, perhaps on purpose to make the point but erroneously, assumes that there is a normal distribution around that equilibrium rate. So in other words to say that there is a normal distribution of unemployment outcomes around a medium-term equilibrium rate of 5.5%. So it is just as likely that something would be down in the twos as it would be up in the eights. Well, who really believes that? Certainly not the MPC and I suspect not the author of that article. It also ignores that the period of time was during the great moderation for all of these variables as well, so it is a relatively short period. These are not normal distributions. You would not expect them. You would expect a skew with quite a fat tail. So using normal calculations to extrapolate from a chart that is there for illustrative purposes is—I will not apply an adjective to it—misleading and I am not sure it is a productive use of our time.
Q82 Steve Baker: That is a fantastic answer. I am much encouraged by it, because it does seem to me it has been known for a long time that it is not reasonable to use normal distributions to model market events and yet so much mathematical economics is based on it.
[KD: Carney’s is an excellent answer: one should not “read in” a normal distribution to this chart, and the Bank explicitly rejects normality in this context.
Slight issue, however: didn’t the Bank’s economists use the normality assumption to represent the noise processes in the models they used to generate the chart? I am sure they did. One wonders how the charts would look if they used more suitable noise processes instead? And just how robust is the chart to the modelling assumptions on which it is based?]
Dr Carney: People do it because it is simple—it is the one thing they understand—and then they apply it without thinking, which is not what the MPC does.
Steve Baker: That is great. I can move on quickly. But I will just say congratulations to the Bank on deciding to commission anti-orthodox research because I think this is going to be critical to drilling into some of these problems.
Dr Carney: Thank you.
[KD: Incredulous chair then intervenes.]
Q83 Chair: To be clear, the conclusion that we should draw from this is that we should look at all economic models with a very high degree of scepticism indeed.
Dr Carney: Absolutely.
[KD: So you heard it from the horse’s mouth: don’t trust those any of those damn models. Still incredulous, the chair then intervenes again to seek confirmation of what he has just heard.]
Chair: Can I just add that it is an astonishing conclusion? I do not want to cut into Steve Baker’s questions, but is that the right conclusion?
Dr Carney: Absolutely. Models are tools. You should use multiple ones. You have to have judgment, you have to understand how the models work and particularly, if I may underscore, dynamic stochastic general equilibrium forecasting models, which are the workhorse models of central banks. What they are useful for is looking at the dynamics around shocks in the short term. What they are not useful for is the dynamics further out where—
[KD: Dr. Carney reiterates the point so there can be no confusion about it. So let me pull his points together: (1) He “absolutely” agrees that “we should look at all economic models with a very high degree of scepticism.” (2) He suggests “You should use multiple [models]”, presumably to safeguard against model risk, i.e., the risks that any individual model might be wrong. (3) He endorses one particular – and controversial – class of models, Dynamic Stochastic General Equilibrium (DSGE) models as the “workhorse models” of central banks, whilst acknowledging that they are of no use for longer-term forecasting or policy projections.
I certainly agree that none of the models is of any longer-term term use, but what I don’t understand is how (1), (2) and (3) fit together. In particular, if we are to be skeptical of all models, then why should we rely on one particular and highly controversial, if fashionable, class of models, never mind – and perhaps I should say, especially – when that class of models is regarded as the central banks’ workhorse. After all, the models’ forecast performance hasn’t been very good, has it?
The discussion then goes from the ridiculous to the sublime:]
Chair: I am just thinking about all those economists out there whose jobs have been put at risk.
Dr Carney: No, we have enhanced their jobs to further improve DSG models.
Steve Baker: We are all Austrians now.
[A little later, Steve asks Sir Jon Cunliffe about the risk models used by banks.]
Q84 Steve Baker: Sir Jon, before I move too much further down this path, can I ask you what would be the implications for financial stability and bank capital if risk modelling moved away from using normal distributions?
Sir Jon Cunliffe: Maybe I will answer the question another way. It is because of some of the risks around modelling, the risk-weighted approach within bank capital, that we brought forward our proposals on the leverage ratio. So you have to look at bank capital through a number of lenses. One way of doing is to have a standardised risk model for everyone and there is a standardised approach and it works on, if you like, data for everybody that does not suit any particular institution and the bigger institutions run their own models, which tend to have these risks in them. Then you have a leverage ratio that is not risk-weighted, and therefore takes no account of these models, and that forms a check. So with banks, the best way to look at their capital is through a number of different lenses.
[KD: Sir Humphrey is clearly a very good civil servant: he responds to the question by offering to answer it in a different way, but does not actually answer it. The answer is that we do not use a non-normal distribution because doing so would lead to higher capital requirements but that would never do as the banks would not be happy with it: they would then lobby like crazy and we can’t have that. Instead, he evades the question and says that there are different approaches with pros and cons etc. etc. – straight out of “Yes, Minister”.
However, notwithstanding that Sir Jon didn’t answer the question on the dangers of the normal distribution, I would also ask him a number of other (im)pertinent questions relating to bad practices in bank risk management and bank risk regulation:
1. Why does the Bank continue to allow banks to use the discredited Value-at-Risk (or VaR) risk measure to help determine their regulatory capital requirements, a measure which is known to grossly under-estimate banks true risk exposures?
The answer, of course, is obvious: the banks are allowed to use the VaR risk measure because it grossly under-estimates their exposures and no-one in the regulatory system is willing to stand up to the banks on this issue.
2. Given the abundant evidence – much of it published by the Bank itself – that complex risk-models have much worse forecast performance than simple models (such as those based on leverage ratios), then why does the Bank continue to allow banks to use complex and effectively useless risk models to determine their regulatory capital requirements?
I would put it to him that the answer is the same as the answer to the previous question.
3. Why does the Bank continue to rely on regulatory stress tests in view of their record of repeated failure to identify the build-up of subsequently important stress events? Or, put it differently, can the Bank identify even a single instance where a regulatory stress test correctly identified a subsequent major problem?
Answer: The Northern Rock ‘war game’. But even that stress test turned out to be of no use at all, because none of the UK regulatory authorities did anything to act on it.
In the meantime, perhaps I can interest readers in my Cato Institute Policy Analysis “Math Gone Mad”, which provides a deeper – if not exactly exhaustive but certainly exhausting – analysis of these issues:
“What will futurity make of the Ph.D. standard ? Likely, it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence – after the Crash of, say, 2016, that wiped out the youngster’s inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal Reserve’s methods.
“I expect you’ll wind up saying something like this: “My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates. We put the cart of asset prices before the horse of enterprise. We entertained the fantasy that high asset prices made for prosperity, rather than the other way around. We actually worked to foster inflation, which we called ‘price stability’ (this was on the eve of the hyperinflation of 2017). We seem to have miscalculated.”
– Excerpt from James Grant’s November 2014 Cato speech. Hat-tip to Alex Stanczyk.
You can be for gold, or you can be for paper, but you cannot possibly be for both. It may soon be time to take a stand. The arguments in favour of gold are well known, and just as widely ignored by the paperbugs, who have a belief system at least as curious because its end product is destined to fail – we just do not know precisely when. The price of gold is weakly correlated to other prices in financial markets, as the last three years have clearly demonstrated. Indeed gold may be the only asset whose price is being suppressed by the monetary authorities, as opposed to those sundry instruments whose prices are being just as artificially inflated to offer the illusion of health in the financial system (stocks and bonds being the primary financial victims). Beware appearances in an unhinged financial system, because they can be dangerously deceptive. It is quite easy to manipulate the paper price of gold on a financial futures exchange if you never have to make delivery of the physical asset and are content to play games with paper. At some point that will change. Contrary to popular belief, gold is supremely liquid, though its supply is not inexhaustible. It is no-one’s liability – this aspect may be one of the most crucial in the months to come, as and when investors learn to start fearing counterparty risk all over again. Gold offers a degree of protection against uncertainty. And unlike paper money, there are fundamental and finite limits to its creation and supply.
What protection ? There is, of course, one argument against gold that seems to trump all others and blares loudly to sceptical ears. Its price in US dollars has recently fallen. Not in rubles, and not perhaps in yen, of course, but certainly in US dollars. Perhaps gold is really a currency, then, as opposed to a tiresome commodity ? But the belief system of the paperbug dies hard.
The curious might ask why so many central banks are busily repatriating their gold ? Or why so many Asian central banks are busily accumulating it ? It is surely not just, in Ben Bernanke’s weasel words, tradition ?
If you plot the assets of central banks against the gold price, you see a more or less perfect fit going back at least to 2002. It is almost as if gold were linked in some way to money. That correlative trend for some reason broke down in 2012 and has yet to re-emerge. We think it will return, because 6,000 years of human history weigh heavily in its favour.
Or you can put your faith in paper. History, however, would not recommend it. Fiat money has a 100% failure rate.
Please note that we are not advocating gold to the exclusion of all else within the context of a balanced investment portfolio. There is a role for objectively creditworthy debt, especially if deflation really does take hold – it’s just that the provision of objectively creditworthy bonds in a global debt bubble is now vanishingly small. There is a role for listed businesses run by principled, decent management, where the market’s assessment of value for those businesses sits comfortably below those businesses’ intrinsic worth. But you need to look far and wide for such opportunities, because six years of central and commercial banks playing games with paper have made many stock markets thoroughly unattractive to the discerning value investor. We suggest looking in Asia. There is a role for price momentum strategies which, having disappointed for several years, though not catastrophically so, now appear to be getting a second wind, from the likes of deflating oil prices, periphery currencies, and so on.
As investors we are all trapped within a horrifying bubble. We must play the hand we’ve been dealt, however bad it is. But there are now growing signs of end-of-bubble instability. The system does not appear remotely sound. Since political vision in Europe, in particular, is clearly absent, the field has been left to central bankers to run amok. The only question we cannot answer is: precisely when does the centre fail ? The correct response is to recall the words of the famed value investor Peter Cundill, when he confided in his diary:
“The most important attribute for success in value investing is patience, patience, and more patience. THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.”
But the absence of patience by the majority of investors is fine, because it leaves more money on the table for the rest of us. The only question remaining is: in what exact form should we hold that money ?
Be patient, and do please set aside thirty minutes to listen to James Grant’s quietly passionate and wonderfully articulate Cato Institute speech. It will be time well spent.
[Editor’s Note: this piece, by John Cochrane, first appeared here http://johnhcochrane.blogspot.ie/2014/11/segregated-cash-accounts.html]
An important little item from the just released minutes of the October Federal Open Market Committee meeting will be interesting to people who follow monetary policy and financial reform issues.
Finally, the manager reported on potential arrangements that would allow depository institutions to pledge funds held in a segregated account at the Federal Reserve as collateral in borrowing transactions with private creditors and would provide an additional supplementary tool during policy normalization; the manager noted possible next steps that the staff could potentially undertake to investigate the issues related to such arrangements.
A slide presentation by the New York Fed’s Jamie McAndrews explains it.
The simple version, as I understand it, seems like great news. Basically, a company can deposit money at a bank, and the bank turns around and invests that money in interest-paying reserves at the Fed. Unlike regular deposits, which you lose if the bank goes under, (these deposits are much bigger than the insured limit) the depositor has a collateral claim to the reserves at the Fed.
This is then exactly 100% reserve, bankruptcy-remote, “narrow banking” deposits. I argued for these in “toward a run-free financial system” as a substitute for all the run-prone shadow-banking that fell apart in the financial crisis. (No, this isn’t going to siphon money away from bank lending, as the Fed buys Treasuries to issue reserves. The volume of bank lending stays the same.)
A second function of such deposits is that, like the new repo facility, it’s going to help the Fed to raise rates. When the Fed wants to raise rates it will pay more interest on reserves. The question is, will banks pass that interest on to depositors? If they were competitive they would, but that’s not so obvious. If large depostitors can access interest-bearing reserves through the repo program, or now through this narrow-banking program, it’s likely to more quickly transmit the interest on reserves to the wider economy.
“Finally, as expectations of rapid inflation evaporate, I want to contribute to the debate about the November 15, 2010 letter signed by 23 US academics, economists and money managers warning on the Fed’s QE strategy. Bloomberg News did what I would call a hatchet job on the signatories essentially saying how wrong they have been and seeking their current views. It certainly made for an entertaining read. Needless to say, shortly afterwards Paul Krugman waded in with his typically understated style to twist the knife in still deeper. Cliff Asness, one of the signatories of the original letter, despite observing that “responding to Krugman is as productive as smacking a skunk with a tennis racket. But, sometimes, like many unpleasant tasks, it’s necessary”, penned a rather wittyresponse. Do read these articles at your leisure. But having been one of the few to accurately predict the deflation quagmire into which we have now sunk, I believe I am more entitled than many to have a view on this subject. Had I been asked I would certainly have signed the letter and would still sign it now. The unfolding deflationary quagmire into which we are sinking will get worse and there will be more Fed QE. But do I think QE will solve our problems? I certainly do not. I think ultimately it will make things far, far worse.”
– SocGen’s Albert Edwards, ‘Is the next (and last) phase of the Ice Age now upon us ?’ (20 November 2014)
On Monday 15th November 2010, the following open letter to Ben Bernanke was published:
“We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.
“We subscribe to your statement in the Washington Post on November 4 that “the Federal Reserve cannot solve all the economy’s problems on its own.” In this case, we think improvements in tax, spending and regulatory policies must take precedence in a national growth program, not further monetary stimulus.
“We disagree with the view that inflation needs to be pushed higher, and worry that another round of asset purchases, with interest rates still near zero over a year into the recovery, will distort financial markets and greatly complicate future Fed efforts to normalize monetary policy.
“The Fed’s purchase program has also met broad opposition from other central banks and we share their concerns that quantitative easing by the Fed is neither warranted nor helpful in addressing either U.S. or global economic problems.”
Among the 23 signatories to the letter were Cliff Asness of AQR Capital, Jim Chanos of Kynikos Associates, Niall Ferguson of Harvard University, James Grant of Grant’s Interest Rate Observer, and Seth Klarman of Baupost Group.
Words matter. Their meanings matter. Since we have a high degree of respect for the so-called Austrian economic school, we will use Mises’ own definition of inflation:
“..an increase in the quantity of money.. that is not offset by a corresponding increase in the need for money.”
In other words, inflation has already occurred, inasmuch as the Federal Reserve has increased the US monetary base from roughly $800 billion, pre-Lehman Crisis, to roughly $3.9 trillion today.
What the signatories likely meant when they referred to inflation in their original open letter to Bernanke was the popular interpretation of the word – that second-order rise in the prices of goods and services that typically follows aggressive base money inflation. Note, as many of them observed when prodded by Bloomberg’s yellow journalists, that their original warning carried no specific date on which their inflation might arise. To put it in terms which Ben Bernanke himself might struggle to understand, just because something has not happened during the course of four years does not mean it will never happen. We say this advisedly, given that the former central bank governor himself made the following observation in response to a question about the US housing market in July 2005:
“INTERVIEWER: Tell me, what is the worst-case scenario? Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?
“BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” [Emphasis ours.]
To paraphrase Ben Bernanke, “We’ve never had a decline in house prices on a nationwide basis – therefore we never will.”
One more quote from Mises is relevant here, when he warns about the essential characteristic of inflation being its creation by the State:
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague.Inflation is a policy.”
Many observers of today’s financial situation are scouring the markets for evidence of second-order inflation (specifically, CPI inflation) whilst either losing sight of, or not even being aware of, the primary inflation, per the Austrian school definition.
James Grant, responding to Bloomberg, commented:
“People say, you guys are all wrong because you predicted inflation and it hasn’t happened. I think there’s plenty of inflation – not at the checkout counter, necessarily, but on Wall Street.”
“The S&P 500 might be covering its fixed charges better, it might be earning more Ebitda, but that’s at the expense of other things, including the people who saved all their lives and are now earning nothing on their savings.”
“That to me is the principal distortion, is the distortion of the credit markets. The central bankers have in deeds, if not exactly in words – although I think there have been some words as well – have prodded people into riskier assets than they would have had to purchase in the absence of these great gusts of credit creation from the central banks. It’s the question of suitability.”
And from the vantage point of November 2014, only an academic could deny that the signatories were wholly correct to warn of the financial market distortion that ensues from aggressive money printing.
Ever since Lehman Brothers failed and the Second Great Depression began, like every other investor on the planet we have wrestled with the arguments over inflation (as commonly understood) versus deflation. Now some of the fog has lifted from the battlefield. Despite the creation of trillions of dollars (and pounds and yen) in base money, the forces of deflation – a.k.a. the financial markets – are in the ascendancy, testimony to the scale of private sector deleveraging that has occurred even as government money and debt issuance have gone into overdrive. And Albert Edwards is surely right that as the forces of deflation worsen, they will be met with ever more aggressive QE from the Fed and from representatives of other heavily indebted governments. This is not a recipe for stability. This is the precursor to absolute financial chaos.
Because the price of every tradeable financial asset is now subject to the whim and caprice of government, rational macro-economic analysis (i.e. top-down investing and asset allocation) has become impossible. Only bottom-up analysis now offers any real potential for adding value at the portfolio level. We discount the relevance of debt instruments almost entirely, but we continue to see merit in listed businesses run by principled and shareholder-friendly management, where the shares of those businesses trade at a significant discount to any fair assessment of their underlying intrinsic value. A word of caution is warranted – these sort of value opportunities are vanishingly scarce in the US markets, precisely because of the distorting market effects of which the signatories to the November 2010 letter warned; today, value investors must venture much further afield. The safe havens may be all gone, but we still believe that pockets of inherent value are out there for those with the tenacity, conviction and patience to seek them out.
According to the ECB’s Bank Lending Survey for October banks eased their credit standards in the last quarter, while their risk perceptions increased.
This apparent contradiction suggests that the 137 banks surveyed were at the margin competing for lower-quality business, hardly the sign of a healthy lending market. Furthermore, the detail showed enterprises were cutting borrowing for fixed investment sharply and required more working capital instead to finance inventories and perhaps to cover trading losses.
This survey follows bank lending statistics since the banking crisis to mid-2014, which are shown in the chart below (Source: ECB).
It is likely that some of the contraction in bank lending has been replaced with bond finance by the larger credit-worthy corporations, and Eurozone banks have also preferred buying sovereign bonds. Meanwhile, the Eurozone economy obviously faces a deepening crisis.
There are some global systemically important banks (G-SIBs) based in the Eurozone, and this week the Financial Stability Board (FSB) published a consultation document on G-SIBs’ capital ratios in connection with the bail-in procedures to be considered at the G20 meeting this weekend. The timing is not helpful for the ECB, because the FSB’s principle recommendation is that G-SIBs’ Tier 1 and 2 capital should as a minimum be double the Basel III level. This gives operational leverage of between 5 and 6.25 times risk-weighted assets, compared with up to 12.5 times under Basel III.
The FSB expects the required capital increase to be satisfied mostly by the issue of qualifying debt instruments, so the G-SIBs will not have to tap equity markets. However, since Eurozone G-SIBs are faced with issuing bonds at higher interest rates than the returns on sovereign debt, they will be tempted to scale back their balance sheets instead. Meanwhile bank depositors should note they are no longer at the head of the creditors’ queue when their bank goes bust, which could affect the non-G-SIB banks with higher capital ratios.
If G-SIBs can be de-geared without triggering a bank lending crisis the world of finance should eventually be a safer place: that’s the intention. Unfortunately, a bail-in of a large bank is unlikely to work in practice, because if an important bank does go to the wall, without the limitless government backing of a bail-out, money-markets will almost certainly fail to function in its wake and the crisis could rapidly become systemic.
Meanwhile, it might appear that the ECB is a powerless bystander watching a train-wreck in the making. Businesses in the Eurozone appear to only want to borrow to survive, as we can see from the October Bank Lending Survey. Key banks are now being told to halve their balance sheet gearing, encouraging a further reduction in bank credit. Normally a central bank would respond by increasing the quantity of narrow money, which the ECB is trying to do despite the legal hurdles in its founding constitution.
However, it is becoming apparent that the ECB’s intention to increase its balance sheet by up to €1 trillion may not be nearly enough, given that the FSB’s proposals look like giving an added spin to contraction of bank credit in the Eurozone.