Authors

Economics

Macro & Market Update

[This piece can be seen at Sean’s blog here http://truesinews.com/2015/02/17/macro-market-update/]

More than half a century ago, in his role as an advisor to the men responsible for trying to set Taiwan on the road to prosperity, a redoubtable economist called Sho-Chie Tsiang argued that the monetary authorities should stop suppressing interest rates and directly rationing credit and should move instead toward a more market-oriented system where real rates were sufficiently elevated to encourage productive saving.

His reasoning was that the existing combination of what we might call Z(Real)IRP with ‘macro-prudential’ control was plagued with several significant drawbacks.

Firstly, rationed credit tended to be crony credit – with only the politically-favoured having any hope of persuading the banks to lend to them. Secondly, the erosion of purchasing power suffered by any one depositing money in the bank at the prevailing yields meant that savers looked for other outlets for their surpluses, such as property and precious metals, neither of which did much to augment the stock of productive capital. Thirdly, this lack of genuine saving meant that all extra funding had to rely on inflationary credit creation and thus necessitated even more macro-prudential monkeying with the price mechanism. Fourthly, anyone outside the charmed circle of accepted borrowers – which tended to mean anyone with a hint of genuine entrepreneurship – had to raise funds in a quasi-illicit and certainly non-transparent manner and so had to promise exorbitantly high ‘curb’ rates of interest to compensate their lenders for the extra hazards involved.

Tsiang argued – and was soon to be proved totally correct in his assertions – that by allowing the rate of interest to find a level where market for funds cleared – essentially where the impulse to thrift intersected the expectation of profit – not only would all these disadvantages be eradicated, but the funding rate applicable to the WHOLE economy, as opposed to that charged to the privileged few, would be lower on average, not higher, as the risk premia associated with the ‘shadow’ market were removed.

In the decades after the Second World War, Taiwan, not entirely coincidentally, transformed itself from a backward, low-value added, crisis-wracked basket case into the economic prodigy to which we still look for so many of our high tech gizmos today.

The reason for the history lesson should be obvious if we consider that much of the same reasoning is relevant to mainland China today, even if the scale of the problem is somewhat larger in a country of 1 1/3 billion people.

Beijing knows that it cannot afford to persist with ‘business as usual’, that the ‘three overhangs’ relating to past over-expansion and misdirected effort have to be overcome while moving to the ‘new normal’ of less force-fed growth-for-growth’s sake. The issues with this are twofold: will the authorities stick to their course, even when the waters get choppy and, if they do, can they then hope to bring the ship of state safely into harbour before the leaks springing from its every timber send it to the bottom?

On the monetary front alone, the issue is fraught. The PBoC, as everyone knows, was moved to cut the required reserve rate a week or so back and so sparked a renewed clamour for further, substantial easing even though the main reason for the reduction was technical: the traditional Lunar New Year cash squeeze was bumping up against the very substantial reserve drain occasioned by the last few months’ sizeable forex outflows.

[CLICK TO ENLARGE ALL GRAPHS]

15-02-16 China M1

Against such a backdrop, the monthly money and credit numbers were exceptionally hard to read. TSF rose, but less than it did in each of the past two years. Loan growth, however, was the second highest on record. On the other side of the balance sheet M2 slowed to a multi-year low increase of 10.2% (even though overall deposits jumped by the most on record!) and yet, within that total, M1 money remained unchanged in a month in which it often falls so its rate of climb therefore rose to a 20-month high of 10.6%. Confusion confounded, indeed!

15-02-16 China TSF

What is key here is that Lui Lei of the central bank came out to argue that any intervention should henceforth only be aimed at alleviating liquidity shortages, not at fostering hothouse growth, while Xu Lin of the NDRC hinted that the latest Five-year Plan would insist on a ‘floor’ for growth of a mere 6.5% – a significant psychological climb down from the economy-doubling 7-handles to which the regime has heretofore grimly clung. Guan Tao of the SAFE next went so far as to make explicit reference to the parallels between his country today and its Asian neighbours back in 1997 on the eve of their great crisis (and he should know: $10 billion+ leaked out again in January, his employers had just revealed).

Courtesy: Bloomberg

For all the worries, this was not enough to prevent the ChiNext from making a new high – taking its run to 233% these past two years. We suspect, however, that it will pay to sell a reversal somewhere in the next 10%. We are also intrigued by the similarity between the HK H-Shares chart and that for pre-collapse crude – or, for that matter, between the index and all manner of commodity-related indices in recent months.

Courtesy: Bloomberg

It is also fascinating to watch sentiment start to dissolve among the US punditry. As the newsflow become more nuanced, market participants have become schizophrenic with regard to oil prices – lower is ‘a tax cut for the consumer’ but is also about to blow up the junk bond market, depending on who is talking. The Dow, for its part, has rallied on cheap energy, but also rallied on a rebound in oil prices which was said to signal continued demand. So long as it rallies, one supposes…

Amid a stretch of numbers which, aside from those concerning employment, were somewhat disappointing to a consensus only lately set four-square behind the thesis of US economic triumphalism, some unusual attention has been paid of late to the lacklustre retail and wholesale sales numbers – mainly becuase they, too, looked weak.

For our part, since these are the nearest thing we get to a timely measure of economy-wide revenues (and hence not just to an NGDP number, all you market monetarists and Neo-Hayekians out there, but to an NSOP – a nominal structure-of-production flow) we tend to pay close attention to them as a matter of routine. What is at issue here, however, is the very fact that these arenominal numbers and are therefore hard to interpret when large, supply-side price changes are underway, as is arguably the case in all things related to natural resources as well as, for the US with its persistently strengthening currency, to imported goods of a more general character.

Since it is the sales margin that ultimately counts for the success of an enterprise, the first thing we need to assure ourselves is that falling revenues need not be wholly bad, as long as costs fall commensurately alongside them. There are, as ever, several caveats to this broad pronouncement.

Firstly, we have to hope that the aggregate decline in selling and buying prices does not mask too great a disparity between conditions in one business and the next. We must also beware the fact that any resulting windfall for one is not ruined by the shortfall for another when the impact is not a simple matter of addition and subtraction but acts in a non-linear fashion – e.g., through its implications for the credit structure. Finally, we have to wonder how the necessary fall in nominal costs will be achieved when it comes to those associated with the payroll. We should all recognise that real wages are what determine our standard of living, but we must also bear in mind that it is the nominal ones over which we fight and for whose maintenance jobs are often sacrificed.

Courtesy: Bloomberg
Courtesy: Bloomberg

With that in mind, let us note three broad trends which are at work. Number one, inventory/sales ratios are rising to levels not seen (barring the Snowball Earth episode of the Lehman Crash) in anything up to thirteen years across manufacturing, wholesale, and retail. To what extent this just reflects a lag in marking down inventory values but having instantlyto recognise lower sale sprices, rather than something much more sinister, only time will tell. Nevertheless, the adjustment, when it comes, will have to be reflected in both a capital write down and a temporary reduction in profits in the relevant period, so there is scope for further anguish.

Courtesy: Bloomberg
Courtesy: Bloomberg

Number two, wage bills in relation to sales receipts have also been pushed to their least favourable in more than a decade and, again, while the marginal return on labour could come out unchanged if the margins are unaltered, lowered revenues could nonetheless serve to jeopardize employment levels. Number three is that the value of outstanding C&I loans is rising in relation to the stock it is financing i.e., collateral coverage is slipping to an extent which may soon start causing jitters among the lenders.

Courtesy: Bloomberg
Courtesy: Bloomberg

While bearing this wobble in mind, also consider that P/Es are back to where they were on the eve of the last crash as is price/book. Price/sales is where it was at the height of the Tech Bubble and returns on capital – measured using both cash flow and free cash flow – are at or approaching their lowest in five years. As ever, the main source of support for the stock market is the deliberately suppressed level of bond yields.

15-02-16 REGF SPX

One way of illustrating this distortion of the bond market is to look at bond risk – such as modified duration – versus bond return, i.e., yield-to-worst. Off the scale, is the simplest way to describe it.

Courtesy: Bloomberg
Courtesy: Bloomberg

As unsustainable as all this looks – not to mention how perilous it all is – the key is to try to find a reversal clear enough to be played. A week or two back, we suggested that the T-bond might be headed to 2.20% and that, if such a level held, one should try to sell against it, scaling in above 2.45/50%. Well, 2.22% has been the low so far and we have had a smart 43bp, 8.3% price reversal since hitting it. So far, so good, so short.

Courtesy: Bloomberg
Courtesy: Bloomberg

As for the rest of the market, WTI is testing the top of a neat profile built at the bottom of the rout (and so, theoretically signalling much lower lows ahead). If it breaks the top of this band, it could swing up to a nice, round $60/bbl where the mid-point of the Thanksgiving Day massacre comes in. Brent looks a touch more positive, so signals are mixed and while not yet convinced we have seen the worst, we would hesitate just yet to position too aggressively as a result of the disparity.

Courtesy: Bloomberg
Courtesy: Bloomberg

Copper, too has seen a little cautious buying, taking it back to the bottom of the old range. On the one hand we have maximum spec shorts both outright and as a percentage of O/I: on the other, the recent, hefty cash premium has almost disappeared as LME inventories have built rapidly, rising 85% since Christmas to a 16-month high. Sell any identifiable failure here but stop out if it does build back above $6000

Courtesy: Bloomberg
Courtesy: Bloomberg

Likewise, gold – while below $1245/50  – stays negative, looking for a possible retest of $1180 and, one day, a break of the decade-old uptrend to usher in the opening up of a route back to the LEH crisis levels down around $800/oz.

If gold is to weaken further, that almost presumes that risk will not spike higher and also that dollar strength will continue at what is now an important technical level for the greenback – at the 50% retracement of the 2002-11 decline and at fairly overbought levels.

Courtesy: Bloomberg
Courtesy: Bloomberg

While below $1.450/00 the euro does not look like spoiling the party but rather giving it a boost by falling to the long-term linear mid at $1.0700 (and possibly, since the trend on this chart has already given way to the log one at $9275/00)

Courtesy: Bloomberg
Courtesy: Bloomberg

However it is espressed in the weakness of pair currencies, a continued USD advance should mean positive feedback with other US asset classes so it is worth noting that the MSCI US index is fast approaching its historic peak relative to the ROW equivalent. Bears will hope that top holds: bulls will be wishing for a full, swing pattern repeat of the 1988-2002 move and hence for much more upside to come.

Courtesy: Bloomberg
Courtesy: Bloomberg

The Nikkei, meanwhile, remains locked – once we peel back the veil of weak Yen money illusion – in the range which has contained it these last 18 months or so. the best hope is that this consolidation wil eventually move the longest line higher both on the medium term scale of the last 5 years of rebound and on the larger scale of the whole three decades of bubble-and-bust.

Courtesy: Bloomberg
Courtesy: Bloomberg

The sad fact remains that, if we adjust for changes in the yen’s international worth via the TWI, returns for the entirety of that period sweep out a quasi-normal, mean reverting distribution. Still, a push to the top of that formation’ s value area would be nothing to sniff at, were it to come about through the processes just discussed.

Courtesy: Bloomberg
Courtesy: Bloomberg

Finally to Europe, where NIRP is beginning to preclude even momentum-driven returns on bonds and is pushing people instead into the stock market. The DAX appears to have broken out against the REX as a result, meaning it has every chance to test the last cyclical highs, set back in 2007, in the weeks ahead.

Courtesy: Bloomberg
Courtesy: Bloomberg

Note, however, that though the idea of European outperformance is becoming more widely shared – not least because of effects of the rapid growth in money supply even pre-QEuro – there is actually little in the graph of Germany v the USA in common currency to suggest this presentiment will be borne out in practice. If you do wish to play for a rise on the Continent, therefore, it seems as though you would be best advised to hedge up your forex exposure when you do so.

Courtesy: Bloomberg
Courtesy: Bloomberg

Good hunting!

Economics

Global economic outlook – update

As recently as 9th January I wrote an article suggesting that 2015 would turn out to be the year of the slump. The title ended with a question mark, but today we are closer to removing it in favour of a definite statement.

In recent weeks, it has become clear that key economic blocs are indeed heading for a slump, including but not limited to China, the Eurozone and Japan (allowing for the distortions of her aggressive money-printing). Between them they account for nearly 40% of global GDP. We know this because of the collapse in commodity prices, which is reflected in a global shift of preference in favour of the US dollar.

For the avoidance of doubt, money should be regarded as a good, and each currency as a different good. When this point is grasped, the context of the dollar’s rise against both commodities and other currencies becomes clear. Both commodities and currencies are priced in dollars, so markets are showing that banks, consumers and businesses have been changing their preferences in favour of increasing their dollar balances.

Modern macroeconomics fails to adequately explain the importance of these developments. A quick look at the index in Keynes’s General Theory makes no mention of changes in preference for money versus other goods. It lists and defines liquidity preference which is a different topic. Once you accept money is a good, supply and demand will always balance as predicated in Say’s Law, otherwise known as the Law of the Markets.

Something has spooked consumers in markets around the world into spending less on other goods and to increase their holdings of dollars. The explanation can only be that prices for all other goods have been too high relative to dollars, so they have had to fall. There can be no clearer signal that there is a slump in global economic activity.

The largest source of exported physical goods is China. Demand from other countries for China’s goods is declining, confirmed by the Baltic Dry Index* which is plumbing new lows. This slow-down in economic activity could easily burst the bubble of bank credit, which is in danger of collapsing under the massive burden of bad debts. December’s slow-down in new loan demand coupled with declining trade flows can only be temporarily resolved by China devaluing the renminbi, thereby lowering her export prices. The breathing space this gives China is only as long as it takes for her manufacturing costs to rise to reflect the devaluation. If it occurs, a renminbi devaluation would quickly put more downward pressure on prices for local manufacturers in her export markets.

Turning to China’s trade partners, we see the Eurozone’s economy ex-Germany beginning to contract which is panicking the ECB into money-printing in a desperate attempt to maintain too-high prices. Japan has been doing this for some time, and is labouring under a mountain of debt that makes even Greece look responsible.

The signals are clear: the world has already entered a downturn in economic activity. Therefore we can expect accelerated money-printing and the imposition of more negative interest rates in a forlorn attempt to avert economic reality.

Economics

A matter of trust

“Popping down to #guardiancoffee later on to order a ‘Toynbee’: short, rich and intensely bitter.”

–       Tweet from Robbie Collin (chief film critic, The Telegraph).

 

We have come a long way since the release of ‘All the President’s Men’. Alan J. Pakula’s 1976 thriller, about the Watergate scandal, may be the first and last film in which the real hero is an institution (The Washington Post, under its principled then executive editor, Ben Bradlee). Or for that matter, not even an institution, so much as an idea: the free press. Robert Redford and Dustin Hoffman may spend their two hours of screentime rushing about having doors slammed in their faces and meeting covert sources in sinister garages, but it’s the idea of the resolute pursuit of truth in the face of administrative obfuscation, peer group indolence, executive greed and a flurry of non-denial denials that lingers long after the titles have rolled. These days, newspapers cut out the middleman and do the bugging themselves.

The concept of a free press has not exactly thrived over subsequent years. Media groups have bulked up into ever more massive, and conflicted, conglomerates. Media channels have proliferated, creating a ‘winner takes most’ competitive environment that has dumbed down everything and crushed audience numbers for anything but the lowest common denominator pap. That catch-all culprit, ‘the Internet’, has facilitated an explosion in the number of amateur content providers that cannot but relentlessly erode the margins of paid-for publishing models. Some of this Schumpeterian creative destruction is to be welcomed. Competition always is. But from an aesthetic and cultural perspective, one is left to wonder whether some industries are better left untouched by those biting digital winds. From the perspective of quality, and in a culture in which time increasingly seems scarcer than money, one sometimes has to ask whether what is free is often far too expensive.

Felix Salmon last week issued an obituary for journalism as usual:

“Labour has almost no leverage over capital any more, which helps explain the rash of “Uber for X” start-ups: they’re nearly all based on the idea that there is a bottomless pool out there of people with smartphones willing to do just about anything (drive a car, go shopping, do laundry, clean an apartment) for $15 an hour. If a company loses one of those workers, it’s no big deal, it just replaces that person with someone else who’s just as good and just as cheap. Now just apply that model to journalists.”

Megan McArdle responded with a less than entirely convincing defence of her own chosen career. Or perhaps she was just expressing Felix Salmon’s concerns from a subtly dissimilar angle:

“..the problem is not competition for eyeballs from new outlets that are writing news in a different, fresher way. The problem is competition for ad dollars from companies that don’t produce news at all. Making news is expensive. It’s hard to compete against companies that don’t bother. Journalism’s biggest threat comes from companies like Google and Facebook that cheaply aggregate our expensive content and sell low-cost, demographically targeted ads in huge numbers. They can kill the whole business.”

Ezra Klein waded in to the debate, and was almost ridiculously upbeat by comparison.

As with so many things, it turns out that Michael Lewis got there before almost everybody:

As you walk through the front door of the Columbia School of Journalism, the first thing you see is this paragraph, cast on a bronze plaque:

“OUR REPUBLIC AND ITS PRESS WILL RISE OR FALL TOGETHER. AN ABLE, DISINTERESTED, PUBLIC-SPIRITED PRESS, WITH TRAINED INTELLIGENCE TO KNOW THE RIGHT AND COURAGE TO DO IT CAN PRESERVE THAT PUBLIC VIRTUE WITHOUT WHICH POPULAR GOVERNMENT IS A SHAM AND A MOCKERY. A CYNICAL, MERCENARY, DEMAGOGIC PRESS WILL PRODUCE IN TIME A PEOPLE AS BASE AS ITSELF. THE POWER TO MOULD THE FUTURE OF THE REPUBLIC WILL BE IN THE HANDS OF THE JOURNALISTS OF FUTURE GENERATIONS.

“..The first sentence on the bronze plaque that you see when you walk through the front door of the Columbia Journalism School may or may not be true, but it sets a fittingly autocratic, unreflective tone. The second sentence is ungrammatical. The last two sentences offer the sort of grandiose vision of journalism entertained mainly by retired journalists or those assigned to deliver speeches before handing out journalism awards. Highly flattering to all of us, of course, but it would be more true to flip the statement to read: “a cynical, mercenary, demagogic people will produce in time a press as base as itself …”

The problem with journalism isn’t just the competitive environment; the problem with journalism is journalists. But our focus here is more specifically on journalism relating to matters of finance and investment. Such journalism tends to fall into one of four categories:

 

  • The omniscient economics correspondent. Invariably a tortured authoritarian still clinging to the discredited remnants of Keynesian economic theory. “QE does work, we just haven’t done enough of it yet.”

 

  • The anti-business zealot. “Everyone should pay their fair share of taxes – especially everybody else.” These social campaigners often come from inherited wealth, and are employed by a tax-advantaged trust.

 

  • The clueless tipster. Spanish practices among the gutter press have poisoned the communal well and led to a generalised suspicion by the public that wealth management is little more than organised insider dealing.

 

 

It is not enough, and it is certainly not accurate, to say that journalists are merely commentators on financial market action. The commentator at a sports match has no ability whatsoever to affect the outcome of the game. But the financial journalist does, depending on the consumer reach of their ‘platform’.

The irony is that most investors might be better served by cutting out the commentary altogether (an irony of which we are, of course, well aware). The psychologist Paul Andreassen showed that people who receive frequent news updates on their investments earn lower returns than those who get no news. The following is from a 2002 Fast Times article:

“The barrage of information and pseudo-information has been magnified by the explosion in financial news over the past decade. In the late 1980s, psychologist Paul B. Andreassen did a series of experiments with business students at MIT that showed that more news does not necessarily translate into better information. Andreassen divided students into two groups. Each group selected a portfolio of stocks and knew enough about each stock to come up with what seemed like a fair price for it. Then Andreassen allowed one group to see only the changes in the prices of its stocks. Students in that group could buy and sell if they wanted, but all they knew was whether the price of a stock had gone up or down. The second group was allowed to see the changes in price and was also given a constant stream of financial news that supposedly explained what was happening with each stock. Surprisingly, the less-informed group did far better than the group that was given all the news.
“The reason, Andreassen suggested, was that news reports tend to overplay the importance of any particular piece of information. When a stock fell, its fall was typically portrayed as a sign that further trouble lay in wait, while a stock that was on the rise seemed to promise nothing but blue skies ahead. As a result, the students who had access to the news overreacted. Because they took each piece of information as excessively meaningful, they bought and sold far more frequently than the people who were just looking at the price.”

The consistently excellent Wall Street Journal columnist Jason Zweig says he was once asked at a journalism conference how he defined his job. His response:

“My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.”

As Zweig puts it, good advice rarely changes, whereas markets change constantly. “The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.”

These are desperate times for investors. Interest rates have been slashed to zero, making a surreal mockery of any sort of savings culture. In some cases they have gone below zero: Bloomberg’s Mark Gilbert points out that negative bond yields are becoming the new normal for many sovereign borrowers, with (clearly terrified) investors willing to pay for the privilege of lending their money to governments. Finland last week auctioned five year notes at minus 0.017%. At least six other countries have five year debt trading at, or below, zero.

At the same time, desperate investors have stampeded into the shares of businesses that seem ostensibly “safe”. In the process, they have bid up the prices of many of those shares to what we consider unsustainable (and probably “unsafe”) levels.

Like us, Zweig sees huge merit in the advice of the legendary value investor, Benjamin Graham:

“The investor’s chief problem – and even his worst enemy – is likely to be himself.”

Another piece of Ben Graham’s advice which we feel is particularly relevant today:

“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.”

That advice could have been written for the market environment of February 2015.

Back to Jason Zweig:

“My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors’ own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.”

Good luck getting an editor to endorse that message.

There is an intriguing post-script to the Watergate story that touches on the venality of human nature (and therefore, more or less directly, on the biddability of politicians). One of the participants in the decision to break into the offices of the Democratic National Committee was Jeb Stuart Magruder. On hearing that the Watergate burglars had been caught, he responded with a degree of bewilderment consistent with an FT or New York Times economics correspondent:

“How could we have been so stupid ?”

Robert Cialdini points out that the original idea for the break-in came from G. Gordon Liddy, who was in charge of intelligence-gathering for the Committee to Re-elect the President (the appropriately monickered CREEP). His proposal was expensive. It required a budget of $250,000 in untraceable cash, and the involvement of no fewer than ten individuals.

But that wasn’t even his first proposal.

His first plan, proposed two months earlier, involved a $1 million programme, featuring a “chase plane”, break-ins, kidnapping and mugging squads, and a yacht featuring “high-class call girls” to blackmail Democratic politicians. The sort of thing that high-ranking IMF officials wouldn’t necessarily be averse to participating in, when not busy saving the world.

Magruder reports that “no-one was particularly overwhelmed with the project” but “after starting at the grandiose sum of $1 million, we thought that probably $250,000 would be an acceptable figure.. We were reluctant to send him away with nothing.”

You do not need to be a senior Republican activist to master this particular strategy. Any seven-year old girl could proffer a similar negotiating gambit:

“If you want a kitten, ask for a pony.”

So you can choose to trust the newspapers. You can choose to trust the marketing businesses masquerading as asset management firms. You can choose to trust bloggers. But you will probably be well served by shrinking, rather than expanding, your universe of advisory inputs, and focusing on a smaller, more focused network of trusted – and trustworthy – serious and intelligent people. If in doubt, trust no-one.

Economics

The Private Equity Boom, Easy Money, and Crony Capitalism

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

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

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

What’s Makes Private Equity Run?

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

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

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

Why There’s So Much Leverage

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

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

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

How Easy Money Enables Private Equity

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

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

The Crony Capitalist Connection

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

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

Private Equity, Shale Oil, and Other Bubbles

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

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

Economics

“A more serious disaster later on..”

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

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

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

 

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

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

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

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

 

 

“It’s a mess, ain’t it, Sheriff ?”

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

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

 

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

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

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

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

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

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

Species of blue-green algae announces IPO

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

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

It gets better. With eerie genius:

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

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

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

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

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

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

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

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

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

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

Enjoy the party, but dance near the door.

 

Economics

Asset managers or asset gatherers?

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

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

 

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

– Richard Feynman on ‘experts’.

 

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

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

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

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

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

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

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

 

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

“the most important person in mutual fund history”.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Economics

Technical Update

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

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

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

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

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

 

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

Courtesy of Bloomberg
Courtesy of Bloomberg

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

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

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

Money

Whatever it Takes

So, finally, the world’s most open conspiracy came to full fruition and Magic Mario actually got to do a little of ‘whatever it takes’ after 2 1/2 long years of bluster. Sweeping aside the objections of what appears to have been most of Northern Europe, the triumph of the Latins was near complete. For all his stubborn resistance, Jens Weidmann proved no Arminius and the airy council rooms of the ECB building in Frankfurt no Teutoburger Wald whose mazy forest tracks and swampy margins proved so deadly to the legions of that earlier Roman legate, Publius Quinctilius Varus.

Indeed, there was some suggestion in the Dutch press that Mario got his way without even putting the issue of his vast ‘stimulus’ programme to a formal vote and so prevented Jens, his fellow German, Sabine Lautenschläger, the Netherlander Klaas Knot, and their Estonian and Austrian colleagues from registering their opposition to the decision and also therefore from making concrete the divisions which it has sharpened within an already fractious governing body.

In pressing ahead with the implementation of its own version of QE, the ECB has taken a further, significant step away from the template of the old Bundesbank and one more towards that of such latter-day, Gosplans of all-intrusive macro-management as the Fed and the PBoC. While any model of central banking is a very poor alternative to a system of genuinely free banking, one cannot quite suppress a pang of nostalgia for the traditions of the ECB’s predecessor, with its rigid insistence on being as far removed from politics as possible; for eschewing any taint of pliant fiscalism; and of sticking reasonably consistently to its primary task of preventing easy money from encouraging reckless behaviour – whether on the part of home-buyers, stock market plungers, Alexander-complex industrialists, or office-hungry politicians.

The hallowed institution of our youth may well have dished out a very tough form of love, but its true virtue was that its heads did not presume to sit at some metaphorical control centre of the economy, constantly flipping switches and pushing buttons to ordain whose traffic lights should be red and whose green; whose heating should be turned up and whose down; whose satellite dish should receive which channels and at what hour. Instead, the old Buba simply tried to ensure that the generators were running smoothly, that there would be neither blackouts nor power surges, and by and large left the choice of what its fellow did with their electricity down to them.

Sadly, as the crisis has dragged on and as the cost in forgone human opportunity has mounted, the established political architecture – a structure populated largely by careerist pygmies who clutch eagerly at anything which might boost them a few points in the next focus group assessment and who are therefore only too happy to absolve themselves of any duty of true statesmanship – has visibly crumbled. That degradation has elevated, almost by default, the central bank itself to the cloud-topped heights of an interventionist Olympus – and rare the presiding member of that august body who does not relish a taste of ambrosia and a sip of nectar before going out to hurl thunderbolts among the weaklings thronging helplessly among the mountain’s gloomy foothills.

No longer is the job seen as one of trying to ensure the wheels do not come off the creaking old Trabant of fractional reserve banking, or of trying to ensure that the nation does write too many cheques – whether issued abroad or at home – against its actual ability to generate income. No, now we must make constant appeal to the gods of central banking to assist us with all the minutiae of our lives in a show of the same touching naivety our ancestors displayed in regard to their tutelary deities. ‘O Holy Draghi, Thrice Blessed One, let it please Thee to ripen the corn in my field, to keep my children’s teeth from rotting too soon, and to allow me to win a few denarii when I play at dice in the tavern this evening!’

Such is the Zeitgeist that we deem it to be sacrilege even to look objectively back at the sorry record of the past seven years lest we start to wonder if we are in fact suffering from is the toxic side-effects of the attempted cure rather than from the disease we are aiming to treat with it. We see it as blasphemy, therefore, to ask whether the sanctimonious Austrian ‘liquidationists’, on the one hand, or those careful Japanese students of their own country’s long malaise – such as Keiichiro Kobayashi and Tadashi Nakamae – on the other, might be right in saying that we Westerners currently have everything back to front in our reasoning.

Might it be so hard to imagine that to try to tempt into renewed borrowing the very people who are still suffering the effects of their previous over-borrowing might not only be economically futile but ethically indefensible, too? Could it be that what is shackling enterprise and hobbling endeavour; that what prevents the crewing of a hopeful new fleet of merchantmen with the slaves loosed from the oars of a now obsolete galley, is the attempt to weld in place the rusted links of their chains of past obligation? Can we not simply strike off the irons even if some do collapse after their manumission? Or must we continue to prevaricate by slyly skewing all contractual terms in favour of the debtors – whether by forcibly suppressing the interest rates applicable to their claims (and so penalising the prudent everywhere); by depreciating the currency in which they are serviced and redeemed (with all the inequities that visits on buyers and sellers); or by transferring the IOUs to the government so that the non-exempt Estates might share the cost through a hike in their already burdensome taxes?

Apparently it is so hard to reconsider our methods that all we are left with is to double and redouble the dose of the poison we have been so unavailingly prescribed. Given the prevalence of this dogma, it was only to be expected that, once it had insidiously secured the political backing for the move, the ECB would not be in any way half-hearted about its first real foray into the world of Bernanke’s ‘making sure it‘ – i.e., that phylloxera of finance, the wasting disease of deflation – ‘doesn’t happen here.’ With a programme of €60 billion a month in bond purchases the Bank will henceforth be gorging on duration to the tune of €720 billion a year, a total heavily in excess of the past five years’ €315 billion average net new sovereign issuance.

Whether it will end up doing more harm than good, or indeed, doing anything at all, is another matter entirely. To see why we say this, we should first recall that Blackhawk Ben himself once tried to allay the fears being provoked by his bond buying drives by saying they were nothing more than an asset swap. Our response at the time was to say, ‘Yes, but you are swapping non-money for money on an unprecedented scale’ – an act that can have the most far-reaching consequences, indeed.

Moreover, the ‘swap’ is not just a monetary, but also an overtly fiscal act if you reckon with the reduction in the interest charged when rolling over some of the outstanding debt, as well as the naked seigniorage to be had from substituting reserves (especially those to which are appended negative interest rates) for higher-yielding securities in all their tens of hundreds of billions. The cynic might say that this is in fact nothing less than the most perfect form of debt repudiation ever carried out in the long, weary infamy of sovereign default.

The fact that the most feared of the likely effects of such a programme – a widespread, self-aggravating spiral of price rises to rage like a pestilence though the markets for goods, services, and labour – has not yet materialised is seen by the smug – and among them, we must count Friend Draghi, with his supercilious call for a ‘statute of limitations’ on the promulgation of such concerns – as a complete justification of their actions.

Ironically, since the QEasers are wedded to the same sort of cart-before-the-horse shamanism that Roosevelt and Morgenthau practised when setting the price of gold over the former’s breakfast egg – namely, the superstition which holds a rise in prices to be in and of itself the most effective trigger for a return to prosperity – the refusal to date of said prices to budge very far at all should have occasioned the Serial Stimulators to question the efficacy of their nostrums and not to stoop to throwing brickbats at those who expect the same thing to ensue which the policy-makers themselves so greatly desire, if admittedly in a somewhat less vigorous fashion than the one the wheelbarrow worrywarts have been publicly dreading.

Faced with the patient’s continued lack of response, the physician should really be posing the question not only of whether the medicine is appropriate for the case but whether he completely misdiagnosed the ailment in the first place. There are many plausible explanations for why recorded ‘inflation’ has been so subdued, among which narratives are several common themes t be found. One such is that the debt overhang and the consequent evergreening of loans keeps other lenders chary of becoming exposed to firms being run for cash at their bankers’ behest lest the first hint of a better liquidation value, or the arrival of a new, get-all-the-bad-news-out-now, broom as CEO, signals a ruinous end to the lender’s forbearance.

Another postulates that the straitened condition of the public treasury leaves people anxious about the next wave of confiscatory taxation. A third contends that mere basis point levels of interest rates are counterproductive in serving to eradicate the necessary distinction between money – whose main purpose is to circulate uninterruptedly from one transaction to the next – and savings – which are supposed to pass the baton of spending on to a third party, giving them the power to transact in one’s place. One can see elements of all these at work today, frustrating the designs of those in command of the printing press.

But yet another feasible diagnosis is that ‘inflation’ is not so much as dead as it is hidden: that its true measure is the admittedly unobservable one of how much policy has propped up prices which should have fallen much, much further when the overabundance caused by the credit-driven malinvestment of the past met with the much lessened appetite and much reduced means of purchase of consumers who also had succumbed to the lure of too much cheap credit in the boom.

Central bankers would view that last scenario as something of a triumph, for they are utterly wedded to the myth that falling prices are especially pernicious in the face of unresponsive or ‘sticky’ wages – a credo to which the Swiss may be about to give the lie as they consider whether to offset the franc’s dramatic rise with the introduction of extra, unpaid hours for workers, or even the dismissal and re-engagement on inferior terms of their entire staff. The central bankers also subscribe to the risible theory that the very expectation that prices may be about to fall is enough to send the Body Economic into an instant catatonia of abstention: a state of utter pecuniary paralysis where we all sit around, bellies rumbling, fires unstoked, children unshod – and latest tech upgrades unqueued for – until those prices finally bottom out.

The greater truth, however, may be that what is being done prevents markets from clearing; that it magnifies entrepreneurial uncertainty (and so effectively raises hurdle rates much faster than low market rates can reduce them); and that, by avoiding the bankruptcy of the few, it ensures the enervation of the many, as sub-marginal businesses cling on to labour and capital which could be better used elsewhere and where the life-support afforded them absorbs too much space on bank balance sheets – much to the detriment of the would-be creatively destructive who must wait in vain to snap up the bargains with which they stand ready to reorder the commercial world.

Beyond this, it is also doubtful whether this sort of QE is even well-grounded in the basic theory of how it is supposed to take effect, rather than at the more rarefied levels we have visited above regarding why we should wish it to do so. While no one can condemn the lack of effort expended by the BOJ, the Fed, the BOE, or even the PBoC, the track record is in truth a spotty one.

This is not least because it is not at all evident that central bank gavage can always do much to get the golden goose laying again. Instead, the record suggests that its creation of vast increments of ‘outside’ money – currency and reserve balances – is not quite so ‘high-powered’ as the textbooks would have us believe, not in a world where it has for long not been banks’ reserve quotients which matter for the application of Liebig’s Law of the Minimum to credit policy. Indeed, if we look at what has happened to the other big central banks when they have opened the sluice-gates, we must conclude that their ‘outside’ money has largely come to substitute, not provide the catalyst for ‘inside’ money creation by the commercial banks.

Take the UK. There, since the Crash of 2008, the BOE has quintupled the monetary base, no less: yet money supply is up only a third (and M4 lending has actually declined £158 billion or ~7%), meaning that while at least positive in this case, the ‘multiplier’ has amounted to a paltry 16p of extra ‘inside’ money for every £1 sterling of the ‘outside’ kind. [Draghi, Deflationistas more generally and retro-Radcliffian ‘total liquidity’ fans should all take note that falling bank lending has been clearly trumped by the impact of rising money supply in exciting Britain’s typically unbalanced recovery]

15-01-27 US AMS-MB

For its part, QEI-III in the US has seen roughly $2.7 trillion added to reserves and so – with currency included – the monetary base has been pumped up by $3.2 trillion since the LEH-AIG crisis. However, money supply proper (essentially M1+) has ‘only’ risen by $1.8 trillion (actually an ‘only’ which constitutes an historically high deviation from trend). This is a combination which bears the construction, therefore, that far from boosting its stock, the Fed has destroyed 45¢ of bank ‘inside’ money for every $1 of the ‘outside’ variety it has injected.

15-01-27 US M1xMB

Capping it all, since the assault on good sense that is Abenomics was first perpetrated two years ago, the BOJ has doubled the monetary base there, an increase of Y138 trillion. Yet M1 has grown by no more than 11%, or Y60 trillion, in that same period, implying that the BOJ has managed to vaporise 57 ‘inside’ sen for every ‘outside’ yen it writes onto its own books.

15-01-27 EZ M1xMB

As for the ECB itself, it has actually managed to keep the nominal money supply growing at the eminently reasonable clip of 6.6% CAR since the Crash. Moreover, 2014 closed with the growth of real money accelerating to almost 7% – a whisker off the best in nearly a decade if we ignore the anomalous rebound from 2008’s tailspin. In the background, the reader should be aware, the monetary base has been wildly erratic as policy has coughed and spluttered, fortunately with very little correlation to what has being going on beyond the corridors of power.

Why is it, then, that the members of the Southern Front of the ECB have pushed through such a controversial policy now? Are they really that anxious to prevent the hard-pressed Spanish housewife from reaping the benefits of lower fuel costs in her household budget? Do they really suppose they will advance the cause of ‘structural’ reform when even the most reckless government can now turn to the Bank to ensure that its debt will always find a willing buyer? Do they think they are unwinding the ‘Doom Loop’ between banks and their governmental masters or that, if they do, this will again spur the banks to lend to every businessmen crossing their threshold or – a proposition harder yet to defend – that it will make businessmen more eager to borrow from the banks? Do they ever stop to work out whether this would be a good thing if it were to occur, rather than a three-lane highway to hell?

One thing the policy will certainly do is bleed income from those very same, sorely afflicted banks their Guardian Angel purports to protect. Why do we say this? Simple arithmetic shows us that once banks have satisfied their circa €100 billion minimum reserve requirement (and earned the associated €50 million interest on it) they start to become subject to the negative deposit rate – as they are already to the tune of around €140 billion in excess holdings. In a year’s time, Messrs. Draghi et Cie will have bought their €720 billion allotment, so banks will be paying 20bps on €860 billion per annum, or €1.72 billion, to their overlords in Frankfurt. Six months later, they will be the grateful recipients of another €360 billion and will be paying a further €720 million to keep them safe, too. Potentially, they will simultaneously lose earnings on their €1.87 trillion in holdings of government securities (the average interest rate at issuance for all of which is 3.0% but whose replacement rate and/or running yield will be not only be appreciably lower now but destined to decline further as a result of the ECB’s actions).

Now given that the Bloomberg European Banks index has a market cap of €900 billion and trades on a multiple of approaching 45, we can see that earnings for its members amount to roughly €20 billion (including the winnings of British, Swiss, and Scandinavian, as well as Euro banks). That €2 billion deposit tax therefore represents a sizeable chunk of profit, even without reckoning on income losses elsewhere in the portfolio and before allowing for the cost of any extra capital which has to be raised as balance sheets swell and leverage ratios rise.

But what of the wider effects? Well, householders earn around €70 billion in net interest a year (before taxes), so that is about to take a hit. They also keep around 60% of their financial assets – a sum of €12.2 trillion as of QI’14 – in the form of deposits, debt securities, and loans, around a third of which resides in their pension and insurance plans rather than being directly owned. Against this, they are collectively on the hook for €6.1 trillion in loans, so putting their chances of loss at twice those of the possibilities for gain even before they start to cough up higher pension contributions and insurance premia as institutional income dwindles.

For all those involved in this grouping, the main hope – apart from some miraculous burst of hiring and productive expansion suddenly occurring in response to Draghi the Magnificent’s latest conjuring trick – is that the notional gains on their €8.2 trillion of equity exposure (€3 trillion of that at the pension and insurance companies) continue to accrue and that these can actually be used to pay the bills, as and when they arrive.

The caveat here is that contained in our previous piece and embedded in our header: that ‘silver is the true sinews of the circulation’. Let us try to explain.

One of the most evident effects of all the reflationary attempts to date is that while it is no more than arguable that they may have had some marginal impact on actual wealth creation above and beyond what would have happened anyway as people readjusted to the post-Crash, they have without doubt unleashed one speculative wave after another in the markets.

Rather than the greater weight of nominal money at people’s disposal being recalibrated as the kind of precautionary realbalance one holds against one’s foreseeable regular outlay on goods and services (a phenomenon which comprises the old-school inflationary reapportionment for which the authorities so yearn), it has taken place in terms of the portfolio balance of assets to be held in a minimal interest rate environment. If the excess money burns a hole in one’s pocket, the ‘inside’ type cannot be collectively diminished, except by paying down debt (and the ‘outside’ type not all unless the central bank is complicit in the deed). Thus, it will be used mainly to pass other assets around in an ascending spiral of price appreciation until a new level of comfort is reached between notional net worth and cash at hand.

The problem is that such a spiral can all so easily go into reverse if the money is now withdrawn from its job of passing parcels between the players so it can be used to buy things outside the circle. Prices will assuredly dip and if the check delivered to the rise in valuations as the first few cash out their chips dislodges one or two too many margined grains of sand, the resulting avalanche can swiftly come to make boring old money seem winningly secure once more and so give rise to further waves of selling. What goes up, and all that.

So has it largely been these past several years. A perceived surfeit of money has not circulated with much renewed vigour against tangible goods and real side transactions, as was hoped would be the case, but it has swirled with often cyclonic fury among all the buyers and sellers, firstly of commodities, then of EM securities, then of junk debt, tech stocks, equities in general, and lately of US equities in particular.

Hence the overstretched valuations in both bond and stock markets and hence the politically-sensitive perception that ‘inequality’ is rising – that only the 1% is benefiting. To the extent that latter charge holds water, the great irony is that – pacePiketty and the rest of the petulant Progressives – it is not because the evil Plutocrats have somehow rigged the game in their favour, but because the Global Left, being avowedly Keynesian-Inflationist for the most part, has got its redistributional arithmetic horribly wrong.

The ‘euthanasia of the rentier’ is not, dear Maynard, taking place to the advantage of the horny-handed sons of toil, nor even to the gain of the scowling industrialists who ‘exploit’ them so mercilessly, but the spoils are rather going to the remuneration committee royalists in the corporat(ist)e boardroom – furnished as it is in C-Suite plush with trimmings of ESOP perverse incentive. And what is true of Davos Man holds true in spades of the grandest of punters of Other People’s Money who can nowfont leurs jeux in a global financial casino made even bigger and brasher than before by the misplaced arguments and ill-judged actions of the Krugmans, Kurodas, Carneys, and Coeurés of this world.

Too low interest rates and falsified capital calculation is at the root of much of what afflicts us, gentlemen of the central bank, and the sooner you accept this truth and retreat humbly to your appointed place, adopting as you do the self-effacing demeanour and taciturn approach of the Bundesbanker of yore, the better it will be for all us in the sorely put-upon 99% for a change.


Addendum: Some members of the Euroclerisy have been stamping their feet in pique in recent days, moaning that the tattered fig leaf offered by Draghi to the dwindling band of constitutionalists – viz., that four-fifths of QE will be a home-grown affair whereby the National Central Banks will be charged with buying whatever bonds and incurring whatever risks they see fit – has been a gross breach of the principle (!) of solidarity and that it enshrines a dreadful obeisance to those outdated tenets of democratic sovereignty which is anathema to all good servants of the Apparat.

That this is nothing more than a straw man, served up to hide their, the QEasers’, end run around the spirit of the law should be obvious from a scan of the Eurobanks’ own accounts (much less from a glance at the still lofty T2 totals extant out there).

As of the third quarter of last year, Euro MFIs had, as a group, non-bank deposit liabilities of €12.2 trillion, 87% of which were taken from individuals and businesses in their own country and just 5% from other members of the Zone. Of the €12.7 trillion in loans to non-banks, again seven-eighths were domestic and a piffling 5% were extended to residents among their Euro ‘partners’. Seen in that light, an inspection of the geographical origin of securities held showed they were, by comparison, the souls of impartiality with a mere 65% issued within the home borders and 23% coming from across the frontier.

That’s integration for you!

Economics

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.

Economics

2015: the year of the slump?

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.

Precious metals

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 09012015

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.

Conclusion

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.