United States of Arithmetic

Credits to the always brilliant xkcd

And the post-election show interviewing the man behind Arithmetic:

Put your finger on a bubble

Paul Krugman has a neat little post on bubbles. He writes:

The point, whether prices are involved or not, is that the expectations of individuals add up to an aggregate impossibility. Bubbles are in fact “natural Ponzi schemes”, in which Bernie Madoff’s place is taken by the invisible hand of confusion.

Social contrivances like fiat currencies are not bubbles because these contrivances can last forever without any failure. They do exist on a basic human element called trust, which is also an emergent property of social systems (similar to value). These emergent properties are present in complex systems existing in critical states, which means that they can alter very rapidly (avalanche effect). Trust can vaporize very quickly. Ask a properly run bank that suffered a failure during the first Great Depression because of a rumor that the bank will fail. Though Krugman reassures us that fiat currencies are not going away any time soon, it is important to remember the (potentially) fragile foundation that they stand on.

Let us take Krugman's clear definition of bubbles and apply it to a hugely overpriced asset called the US Treasuries. I say overpriced because the price of bonds have never been this high, ever. Courtesy of the excellent chart makers at itulip , here are a few pictures.

The insanely overpriced bonds are possible by the theoretically infinite balance sheet of the Fed where they can swap base money for US Treasuries.

 

Anybody who was brave enough to short US Treasuries in 2008 (following the advice of Peter Schiff) got clobbered because of two reasons: a) US Treasuries are still a safe haven in the world's consciousness and b) the Fed stepped in big-time with quantitative easing programs which have led Treasury prices to rise even further, due to nonlinear effects. Can bond prices go on rising forever?

Sure, the Fed's balance sheet is infinite (theoretically). But is it infinite? As analyst Eric Janszen points out intelligently:

Because the Fed's balance sheet isn't really infinite. It is only infinite for as long as everyone believes that it is.

To tie together the thoughts of Krugman and Janszen, individuals expecting bond prices to rise indefinitely, complicated further by the fact that central banks acting as a bidder of last resort -- this situation can continue only as long as it can't.

What then about gold, which is anti-correlated to the real interest rates? As Krugman points out in one of his blog entries on gold:

The logic, if you think about it, is pretty intuitive: with lower interest rates, it makes more sense to hoard gold now and push its actual use further into the future, which means higher prices in the short run and the near future. But suppose this is the right story, or at least a good part of the story, of gold prices. If so, just about everything you read about what gold prices mean is wrong.

Brad Delong points this out well in his entry on gold boom:

On this interpretation gold is and always has been a super Treasury bond: a very long duration asset that is or at least is perceived to be "safe" in the sense that its price does not trade at a discount (due to risk and default premia) from a Treasury bond of the same duration but instead trades at a premium.

As more certainty emerges on future outlook and expectations, interest rates adjust to them and gold price being sensitive to long-term interest rates will also adjust accordingly. 

Is a Treasury bond (or its inverse, gold) in a bubble? Depends on the level of trust (or otherwise) in the system and whether this assessment of trust adds up to an aggregate impossibility.

Stagnation as far as the eyes can see

Jesse, host of a very popular blog gave an excellent interview with Ilene of MarketShadows. The whole interview is worth a read and has nuggets of intelligent observations.

Some excerpts from the interview:

The Fed stabilized the patient, but the patient remains in the ICU because the doctors cannot agree on the treatment. And of course, the medical directors are stealing the medicine and selling it on the black market. So we have quite the dilemma.

The credibility trap is preventing genuine reform, and the financial system is continuing to distribute the bulk of all new income growth to the wealthiest few, which leaves the vast middle with little discretionary income to fuel demand and organic growth. It is a false equilibrium, but these can last for a decade or more. It really depends on what causes things to change. But change will come.

Self-fulfilling prophecy in real time

Prof. James Hamilton of UCSD has published a nice piece on why Californians are experiencing high gas prices over the past week. NBC San Diego has reported:

"many rushed to fill up their tanks Friday night for fear of prices soaring again over the weekend."

The social scientist Robert Merton coined the term self-fulfilling prophecy, which is that people believing something to be true makes the event to become true, even if the event had not originally happened in the first place. This link has a good explanation on SFP. Quoted from the link:

SFP is a particular type of dynamic process. It is not the truism that people’s perceptions depend on their prior beliefs. Nor is it the truism that beliefs, even false ones, have real consequences. To count as SFP, a belief must have consequences of a peculiar kind: consequences that make reality conform to the initial belief. Moreover, I argue that there is an additional defining criterion. The actors within the process—or at least some of them—fail to understand how their own belief has helped to construct that reality; because their belief is eventually validated, they assume that it had been true at the outset.

People believing crude oil prices heading higher causes crude oil prices to become higher. 

Maturity Transformation and Duration Mismatch

Paul Krugman conveys an idea in words better than anyone else regarding the topic that is at the heart of modern banking: maturity transformation. In simple terms, individual savers deposit their money with the banks. These funds should be available on demand, because the savers can withdraw these on demand [hence the term demand deposit]. But the banks are allowed to loan these funds to borrowers for a specified amount of duration agreeable between the bank and the borrower. In this post, Krugman writes clearly:

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Prof. Krugman is talking about a dilemma, similar to Triffin Dilemma, but at a much more basic level. Triffin Dilemma deals with the consequences of using a single country's currency as the world reserve currency (which gives the single country an exorbitant privilege). Prof. Krugman recognizes that the same medium used by both the individual savers and the people requiring funds for productive investment leads to a conflict between both parties. If they both have different goals, why not use a different medium? [For the interested readers about a monetary system thesis where medium of exchange is decoupled from store of value, please consider this link.]

Prof. Krugman doesn't get to that part though, in his discussion. Note also that how he refers to requirements of productive investment but ignores borrowing for non-productive needs (such as for e.g., buying a house because prices and rising).  Not all borrowing is of high quality and not all borrowing is done for the feasible term structure. A borrower wants to borrow at the maximum duration with the lowest interest rate possible, but a saver whose funds get lent may not accept the same terms. There is a yield spread in this case (bid and an offer, there is no such thing as a monolithic price) and market dynamics help figure out the duration/interest rate details. But if a central bank mucks with this market signal, what happens as a consequence? The market will eventually run out of qualified borrowers. There happens a disco-ordination of natural social interaction when the key signal of interest rate is messed up.

What if we do listen to what hard money advocates want? As Prof. Krugman rightly points out, there will be more panic crashes. The times when US and the world was on a fixed gold standard was very painful for a number of reasons. When credit expands beyond what can be meaningfully serviced by the economy, the credit levels naturally will contract. But under a fixed gold standard, credit is denominated in gold which causes the contraction to be extremely severe. There will be too much collateral damage. Even businesses that were operating under a reasonable profit margin and less debt would fail. This is what happened during Great Depression I. 

America had no major financial panics other than in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933. Oh, wait. The truth is that returning to gold is an almost comically (and cosmically) bad idea.

In the same post on outlawing banks, Krugman talks about a task that banks engage in a normal fashion, borrowing short to lend long. He writes:

Any arrangement that borrows short and lends long, that offers investors claims that are liquid while using their funds to make illiquid investments is a bank in an economic sense — and is potentially subject to bank runs.

But there is another operation which is mostly unnoticed in mainstream economic circles and which essentially renders quantitative easing as a fuel added to the fire of deflation. The Fed could be unwittingly contributing to more deflation while engaging in an attempt to devalue the dollar. Professor Fekete has written several articles on risk free bond speculation, where the speculators are engaging in the same activity of borrowing short to lend long. It is clear that borrowing short to lend long is at least a dubious idea which can have negative long-term consequences.

Let's take an example and understand the duration mismatch problem in a concrete fashion. I want to borrow $250,000 for a 30 year loan. Assuming that the banks cannot create deposits to fulfill a loan without any reserves, will any one even lend me that sum for such a long duration? Even if I cannot find a willing lender who can accept the duration and the sum, will the interest rate be acceptable to me (the borrower) so that the deal can actually happen? Probably not, the interest rate charged may be exorbitant depending on available credit conditions (when there is a natural limit on credit creation). If a central bank mucks with the interest rates and keeps them artificially low for too long, may be I could borrow (but I shouldn't under normal circumstances). This has created a mispricing of risk which goes undetected initially but a fault nevertheless in the overall system.

Through this discussion one aspect becomes very clear: a person depositing funds at the bank should get to choose their time preference on those funds (and the fraction that should be available upon demand). Secondly, a honorable bank should match this duration for a qualified borrower. Vetting the borrower and matching the duration is the bank's job. Even prior to deciding the time preference of the saver's portion of loanable funds, the saver gets to make an arbitrage: what fraction to save and what fraction to leave as time deposits. What if the medium to save was completely different from the medium to transact/invest/loan etc.? Does that resolve this conflict which gets created between creditors and borrowers?

James Madison and the Credibility Trap

Justice is the end of government. It is the end of civil society. It ever has been and ever will be pursued until it be obtained, or until liberty be lost in the pursuit. 

But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government. 

 
 - James Madison, Federalist No. 51

A group of humans is a system of complex systems (each agent is a complex system of their own) and there are dynamic feedback loops to ensure the system does not disintegrate. Madison refers to these dynamic loops to ensure system integrity when he talks about the primary control on the Government.

Jesse talks about the credibility trap here:

A credibility trap is when the regulatory, political and/or informational functions of a society have been compromised by a corrupting influence and a fraud, so that they cannot address the situation without implicating, at least incidentally, a broad swath of the power structure including themselves. 

I think the checks and balances do not exist to ensure system integrity therefore increasing the risk of a catastrophe.

Open ended QE

The Federal Reserve announced open-ended QE last week, which is unprecedented for any central bank and its implications (positive or negative effects) are not very well understood yet.  Here is the Fed's press release.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

In addition to the ongoing Operation Twist (extending duration of the Fed's portfolio), the Fed has also decided to purchase agency-backed MBS for the tune of $40 billion a month, until the labor market improves. They have not clearly specified the target they are looking at, which is worrisome.

In any event, this press release and the decision making by the Fed is seen as a victory for the Market Monetarists such as David Beckworth, Scott Sumner and a few others. These people have been vocal about the need for the Fed to target NGDP (nominal GDP) and therefore set market expectations that it will do whatever it takes to restore NGDP to trend growth. This, they believe will alter the market psychology (because the Fed is a monetary super power) and therefore boost spending, hiring, wages and the road towards recovery.

But the whole thesis is hinged on one simple assumption: aggregate demand short fall. Is that the real reason behind the economic malaise? What is the root cause if it is not aggregate demand? Is aggregate demand merely a symptom of a system that has taken on too much private debt? Is the system too centralized and therefore prone to fragility? Consider this post by John Aziz.

My theory is this: our depression is not a problem of insufficient demand. It is systemic; most prominently and immediately financial fragility, financial zombification, moral hazard, and excessive private debt, alongside a huge number of other long-term systemic problems.

What if the Fed and the market monetarists are completely wrong? What if all central banks engage in a competitive devaluation strategy and these currency wars precipitate into trade or real wars? Here is Ed Haddas from Reuters:

It is a dangerous way to conduct monetary policy. A large trade surplus may have helped create jobs in China, but the accumulated funds helped finance the asset bubbles which eventually popped, leading to the current global malaise. The Fed’s previous rounds of quantitative easing just might have helped the American economy, but they almost certainly pushed up commodity prices, which stimulated economic and political tension in many poor countries. They also spawned ill will among the central bankers who were forced to deal with collateral damage from the U.S. war against domestic financial disorders.

Analyzing quantitative easing

I am using this post as a vehicle to document the different views on quantitative easing and their relative merits/demerits. The conventional view point is as follows:

GDP = C + I + GS + Net exports

C= Consumption  (private sector)

I = Investment (private sector)

GS= Government Spending (public sector)

Net exports = the difference between total exports and total imports

In order to boost GDP, one should be able to increase any of the 4 factors. It is a well-known fact that households and the private sector are saturated with debt and the deleveraging process has just begun. Therefore consumption cannot be easily boosted if debt levels are elevated.  Even though interest rates remain repressed through QE, the lower interest rates cannot immediately spur further borrowing because this borrowed money cannot be easily serviced when wages are stagnant. Although the Fed's reasoning is that lower interest rates will encourage more consumer spending, it cannot sustain itself because of saturated debt levels.

Investment can be boosted by reducing effective corporate tax rates, but there should be consumption capacity for the investment to take place. When consumption capacity is low, then regardless of the tax rates -- new investments cannot happen. It is a vicious cycle.

The political appetite for government spending determines whether it can be increased. Clearly since 2011, the debate on the US political spectrum has shifted towards the debt ceiling and therefore the political appetite for increasing spending is waning.

This leaves us with net exports. Exports can be increased either by exporting more goods and services or by exporting the same goods and services but devalue the currency. Devaluing the currency has negative consequences as well. US imports are much higher than US exports, therefore the cost increase in imports (since a devalued dollar means US pays more for imports)  could overwhelm the gain in exports and net effect can still continue to be negative. There's quite a bit of non-linearity in all this discussion, so it is important to bear this in mind. Cost of imports may not immediately increase, for example because the dollar inflation is not immediately detected (dollar being the world reserve currency).

James G Rickards, a renowned financial expert explains the above as the Fed's rationale for QE2 and further QE, in his popular book Currency Wars.

There are two other alternative views which I would like to highlight. Professor Fekete writes about the risk-free bond speculation in his article There is no Business like Bond Business, Still. Here's his 2010 article on the same subject. The professor makes a valid point that the primary dealers can front-run the Fed (since the Fed announces when it is going to buy and how much before market opens) and then flip the bonds back to the Fed at a higher price and pocket risk-free profits.

This means that interest rates keep going lower and lower until this game cannot continue.As interest rates keep going lower and lower, it is harder to service the previously acquired debt because the income stream keeps reducing. It is a perverse effect since the Fed is trying to fight deflation, but actually making the pain worse. He compares the current paradigm to an economic resonance with a built-in runaway vibration that can snap the whole system(similar to Tacoma Bridge collapse of 1940). Here's an excerpt from his article titled 'Premature Obituaries (for the dollar)'.

When the energy level of the self-boosting system overwhelms centripetal forces, the system snaps like a broken chain, releasing the surplus energy most destructively. This is the substance of every crack-up boom. Like Mises, I also object to the use of the word hyperinflation, albeit for a different reason. It suggests that the phenomenon is linear and follows the laws of the Quantity Theory of Money. The more money is printed, the higher do prices go. However, we are here facing highly non-linear phenomena. Our economy is torn to pieces by runaway vibration. We are victimized by the self-destruction of the monetary system subjected to oscillating money-flows boosted by the resonance of fluctuating interest rates resonating with fluctuating prices.

The other alternative view that I want to highlight is that of a popular blogger, FOFOA who writes on two topics: a) dollar hyperinflation and b) Freegold monetary theory. In his post Inflation or Hyperinflation, he details how QE is all about managing the unstoppable flow of Treasuries.

The USG today is spending $3.6B more than it is taking in, each and every day. That's a big mess of dollars flooding out of the USG. $1.5B per day is flooding outside of our zone while $2.1B is staying right here on our front lawn. This is all flow. It is ongoing and unstoppable. And it all must be mopped up by someone. And by someone, I mean either the foreign sector, the domestic private sector or the Fed buying up US Treasuries. $3.6B per day, an unstoppable, unending broken water main gushing out dollars. Marginal flow!

Don't be fooled by the misdirection. QE, twist, whatever; it's not about interest rates or helping the economy recover. It's 100% about disguising and managing this uncontrollable, unstoppable mess. It's more like a broken sewer line than a water main now that I think about it.

Sure, the Fed needs to keep interest rates from rising. Because what happens when interest rates rise? The value of the entire $35T bond market starts to collapse and bond holders panic. The Fed doesn't want that, so don't bet on them letting interest rates rise. But as I said, I'm not worried about the stock of dollars. I'm worried about this broken sewer line we call the federal budget deficit which means no one has to sell a single bond. In fact, someone has to continuously buy $3.6B more each and every day, including weekends and holidays.

In another post titled Moneyness, FOFOA writes:

The USG thinks (and truly believes) that the key to rejuvenating the US economy is trashing the dollar as a short cut to increasing exports (reducing the trade deficit). But what it can't see (nor anyone that focuses solely on the monetary plane for adjustment) is that the huge trade deficit the USG wants to quit is actually its own heroin fix. This is a deadly combo for the US dollar.

The key point to take away is that Budget Deficit and Trade deficit are inter-related in the sense that government spending towards goods and services increases our imports, therefore worsening the trade deficit.

To summarize, following are the stated or unstated effects of quantitative easing:

1. Lower interest rates to boost consumer borrowing and spending (Fed's take, but not true in the real world because the transmission mechanism is broken when debt levels are saturated)

2. Increase exports through cheaper dollar, which causes global inflation and boosts US GDP (Rickards's take in his book -- this is supported with some empirical data and real world evidence)

3. Risk-free bond speculation reinforces a feedback loop of lower and lower interest rates leading to capital destruction until the system cannot handle this anymore (Fekete's take -- interest rates are heading lower even though they take a wibbly wobbly path)

4. Manage US Government budget deficit and sustain the US trade deficit amidst political gridlock and unwillingness to raise taxes or cut spending (FOFOA's take -- plausible explanation)

But one aspect is quite clear. QE is a grand experiment where consequences are unknown and there are several negative effects (because of the fact that it is implemented on a complex system with non-linear effects) which are hardly discussed by the Fed.

Unintended Consequences

Humans are notoriously famous for engaging in Faustian bargains. An excellent paper has been published by William White, currently Chairman at the Economic Development and Review Committee at the OECD in Paris. The subject is ultra easy monetary policy and its effect on the macro economy. Full paper can be accessed here

Even the footnotes on the paper contain fantastic information like this:

1. Crises occur on a regular basis in complex systems. They also conform to a Power Law linking the frequency of crises to the inverse of their magnitude. 

2. Predicting the timing of individual crises is impossible.

3.There is no relationship between the size of the triggering event and the magnitude of the subsequent crisis. This way of thinking helps explain why “the Great Moderation” could have been followed by such great turbulence, and why major economic crises have generally emerged suddenly and with no clear warning.

Conclusions of the paper note that, ultra easy monetary policies have the following unintended undesirable effects:

1. Mal investments in the real physical plane of the economy

2. The health and viable functioning of financial institutions and markets are threatened

3. Central bank independence from the Government is constrained (central banking becomes more and more political, inching us closer towards Zimbabwe Hyperinflation)

4. Governments are actively encouraged to not do any meaningful fiscal policy reforms

So overall, lowering interest rates through outright bond buying (debt monetization, also known as quantitative easing) is not a free lunch, but actually a Faustian bargain (buying short term pleasure at the expense of long term pain).