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Hoisington Investment Management – Quarterly Review and Outlook, Second Quarter 2014

The Hoisington Investment Management quarterly review and outlook Via John Mauldin Economics

Treasury Bonds Undervalued

Thirty-year treasury bonds appear to be undervalued based on the tepid growth rate of the U.S. economy. The past four quarters have recorded a nominal “top-line” GDP expansion of only 2.9%, while the bond yield remains close to 3.4%. Knut Wicksell (1851-1926) noted that the natural rate of interest, a level that does not tend to slow or accelerate economic activity, should approximate the growth rate of nominal GDP. Interest rates higher than the top-line growth rate of the economy, which is the case today, would mean that resources from the income stream of the economy would be required to pay for the higher rate of interest, thus slowing the economy. Wicksell preferred to use, not a risk free rate of interest such as thirty-year treasury bonds, but a business rate of interest such as BAA corporates.


As chart one attests, interest rates below nominal GDP growth helps to accelerate economic activity and vice versa. Currently the higher interest rates are retarding economic growth, suggesting the next move in interest rates is lower.

To put the 2.9% change in nominal GDP over the past four quarters in perspective, it is below the entry point of any post-war recession. Even adjusting for inflation the average four-quarter growth rate in real GDP for this recovery is 1.8%, well below the 4.2% average in all of the previous post-war expansions.

Fisher’s Equation of Exchange

Slow nominal growth is not surprising to those who recall the American economist Irving Fisher’s (1867-1947) equation of exchange that was formulated in 1911. Fisher stated that nominal GDP is equal to money (M) times its turnover or velocity (V), i.e., GDP=M*V. Twelve months ago money (M) was expanding about 7%, and velocity (V) was declining at about a 4% annual rate. If you assume that those trends would remain in place then nominal GDP should have expanded at about 3% over the ensuing twelve months, which is exactly what occurred. Projecting further into 2014, the evidence of a continual lackluster expansion is clear. At the end of June money was expanding at slightly above a 6% annual rate, while velocity has been declining around 3%. Thus, Fisher’s formula suggests that another twelve months of a 3% nominal growth rate is more likely than not. With inflation widely expected to rise in the 1.5% to 2.0% range, arithmetic suggests that real GDP in 2014 will expand between 1.0% and 1.5% versus the average output level of 2013. This rate of expansion will translate into a year-over-year growth rate of around 1% by the fourth quarter of 2014. This is akin to pre-recessionary conditions.

An Alternative View of Debt

The perplexing fact is that the growth rate of the economy continues to erode despite six years of cumulative deficits totaling $6.27 trillion and the Federal Reserve’s quantitative easing policy which added net $3.63 trillion of treasury and agency securities to their portfolio. Many would assume that such stimulus would be associated with a booming economic environment, not a slowing one.

Readers of our letters are familiar with our long-standing assessment that the cause of slower growth is the overly indebted economy with too much non-productive debt. Rather than repairing its balance sheet by reducing debt, the U.S. economy is starting to increase its leverage. Total debt rose to 349.3% of GDP in the first quarter, up from 343.7% in the third quarter of 2013.

It is possible to cast an increase in debt in positive terms since it suggests that banks and other financial intermediaries are now confident and are lowering credit standards for automobiles, home equity, credit cards and other types of loans. Indeed, the economy gets a temporary boost when participants become more indebted. This conclusion was the essence of the pioneering work by Eugen von Böhm-Bawerk (1851-1914) and Irving Fisher which stated that debt is an increase in current spending (economic expansion) followed by a decline in future spending (economic contraction).

In concert with this view, but pinpointing the negative aspect of debt, contemporary economic research has corroborated the views of Hyman Minsky (1919-1996) and Charles Kindleberger (1910-2003) that debt slows economic growth at higher levels when it is skewed toward the type of borrowing that will not create an income stream sufficient to repay principal and interest.

Scholarly studies using very sophisticated analytical procedures conducted in the U.S. and abroad document the deleterious effects of high debt ratios. However, the use of a balance sheet measure can be criticized in two ways. First, income plays a secondary role, and second, debt ratios are not an integral part of Keynesian economic theory.

We address these two objections by connecting the personal saving rate (PSR) which is at the core of Keynesian economic analysis, and the private debt to GDP ratio that emerges from non-Keynesian approaches. Our research indicates that both the “Non-Keynesian” private debt to GDP ratios, as well as the “Keynesian” PSR, yield equivalent analytical conclusions.

The Personal Saving Rate (PSR) and the Private Debt Linkage

The PSR and the private debt to GDP ratio should be negatively correlated over time. When the PSR rises, consumer income exceeds outlays and taxes. This means that the consumer has the funds to either acquire assets or pay down debt, thus closely linking the balance sheet and income statement. When the PSR (income statement measure) rises, savings (balance sheet measure) increases unless debt (also a balance sheet measure) declines, thus the gap between the Keynesian income statement focus and the non-Keynesian debt ratio focus is bridged.

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The PSR and private debt to GDP ratio are, indeed, negatively correlated (Chart 2). The correlation should not, however, be perfect since the corporate sector is included in the private debt to GDP ratio while the PSR measures just the household sector. We used the total private sector debt ratio because the household data was not available in the years leading up to the Great Depression.

The most important conceptual point concerning the divergence of these two series relates to the matter of the forgiveness of debt by the financial sector, which will lower the private debt to GDP ratio but will not raise the PSR. The private debt to GDP ratio fell sharply from the end of the recession in mid-2009 until the fourth quarter of 2013, temporarily converging with a decline in the saving rate. As such, much of the perceived improvement in the consumer sector’s financial condition occurred from the efforts of others. The private debt to GDP ratio in the first quarter of 2014 stood at 275.4%, a drop of 52.5 percentage points below the peak during the recession. The PSR in the latest month was only 1.7 percentage points higher than in the worst month of the recession. Importantly, both measures now point in the direction of higher leverage, with the PSR showing a more significant deterioration. From the recession high of 8.1%, the PSR dropped to 4.8% in April 2014.

Historical Record

The most recently available PSR is at low levels relative to the past 114 years and well below the long-term historical average of 8.5% (Chart 3). The PSR averaged 9.4% during the first year of all 22 recessions from 1900 to the present. However this latest reading of 4.8% is about the same as in the first year of the Great Depression and slightly below the 5% reading in the first year of the Great Recession.

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In Dr. Martha Olney’s (University of California, Berkeley and author of Buy Now, Pay Later) terminology, when the PSR falls households are buying now but will need to pay later. Contrarily, if the PSR rises households are improving their future purchasing power. A review of the historical record leads to two additional empirical conclusions. First, the trend in the PSR matters. A decline in the PSR when it has been falling for a prolonged period of time is more significant than a decline after it has risen. Second, the significance of any quarterly or annual PSR should be judged in terms of its long- term average.

For example, multi-year declines occurred as the economy approached both the Great Recession of 2008 and the Great Depression of 1929. In 1925 the PSR was 9.2%, but by 1929 it had declined by almost half to 4.7%. The PSR offered an equal, and possibly even better, signal as to the excesses of the 1920s than did the private debt to GDP ratio. Both the level of PSR and the trend of its direction are significant meaningful inputs.

John Maynard Keynes (1883-1946) correctly argued that the severity of the Great Depression was due to under-consumption or over-saving. What Keynes failed to note was that the under-consumption of the 1930s was due to over-spending in the second half of the 1920s. In other words, once circumstances have allowed the under-saving event to occur, the net result will be a long period of economic under-performance.

Keynes, along with his most famous American supporter, Alvin Hansen (1887-1975), argued that the U.S. economy would face something he termed “an under-employment equilibrium.” They believed the U.S. economy would return to the Great Depression after World War II ended unless the federal government ran large budget deficits to offset weakness in consumer spending. The PSR averaged 23% from 1942 through 1946, and the excessive indebtedness of the 1920s was reversed. Consumers had accumulated savings and were in a position to fuel the post WWII boom. The economy enjoyed great prosperity even though the budget deficit was virtually eliminated. The concerns about the under-employment equilibrium were entirely wrong. In Keynes’ defense, the PSR statistics cited above were not known at the time but have been painstakingly created by archival scholars since then.

Implications for 2014-2015

In previous letters we have shown that the largest economies in the world have a higher total debt to GDP today than at the time of the Great Recession in 2008. PSRs also indicate that foreign households are living further above their means than six years ago. According to the OECD, Japan’s PSR for 2014 will be 0.6%, virtually unchanged from 2008. The OECD figure is likely to turn out to be very optimistic as the full effects of the April 2014 VAT increase takes effect, and a negative PSR for the year should not be ruled out. In addition, Japan’s PSR is considerably below that of the U.S. The Eurozone PSR as a whole is estimated at 7.9%, down 1.5 percentage points from 2008. Thus, in aggregate, the U.S., Japan and Europe are all trying to solve an under-saving problem by creating more under-saving. History indicates this is not a viable path to recovery. [reference: Atif Mian and Amir Sufi,. House of Debt, University of Chicago Press 2014]

Japan confirms the experience in the United States because their PSR has declined from over 20% in the financial meltdown year of 1989 to today’s near zero level. Japan, unlike the U.S. in the 1940s, has moved further away from financial stability. Despite numerous monetary and fiscal policy maneuvers that were described as extremely powerful, the end result was that they have not been successful.

U.S. Yields Versus Global Bond Yields

Table one compares ten-year and thirty-year government bond yields in the U.S. and ten major foreign economies. Higher U.S. government bond yields reflect that domestic economic growth has been considerably better than in Europe and Japan, which in turn, mirrors that the U.S. is less indebted. However, the U.S. is now taking on more leverage, indicating that our growth prospects are likely to follow the path of Europe and Japan.

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With U.S. rates higher than those of major foreign markets, investors are provided with an additional reason to look favorably on increased investments in the long end of the U.S. treasury market. Additionally, with nominal growth slowing in response to low saving and higher debt we expect that over the next several years U.S. thirty-year bond yields could decline into the range of 1.7% to 2.3%, which is where the thirty-year yields in the Japanese and German economies, respectively, currently stand.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Review and Forecast by Gary Shilling

Via John Mauldin, Mauldin Economics

It’s that time of year again, when we begin to think of what the next one will bring. I will be doing my annual forecast issue next week, but my friend Gary Shilling has already done his and has graciously allowed me to use a shortened version of his letter as this week’sThoughts from the Frontline. So without any further ado, let’s jump right to Gary’s look at where we are and where we’re going.

Review and Forecast

By Gary Shilling

In the third quarter, real GDP grew 2.8% at annual rates from the second quarter. Without the increase in inventories, the rate would be 2.0%, in line with the 2.3% average growth since the economic recovery commenced in the second quarter of 2009.

Furthermore, the step-up in inventory-building from the second quarter may have been unintended, suggesting cutbacks in production and weaker growth in future quarters. Also, consumer spending growth, 1.5% in the third quarter, continues to slip from 1.8% in the second quarter and 2.3% in the first while business spending on equipment and software actually fell at a 3.7% annual rate for only the second time since the recovery started in mid-2009. Government spending was about flat with gains in state and local outlays offsetting further declines in federal expenditures. Non-residential outlays for structures showed strength as did residential building. The 16-day federal government shutdown didn’t commence until the start of the fourth quarter, October 1, but anticipation may have affected the third quarter numbers.

Recovery Drivers

The 2.3% average real GDP growth in the recovery, for a total rise of 10%, has not only been an extraordinarily slow one but also quite unusual in structure. Consumer spending has accounted for 65% of that growth, actually below its 68% of real GDP, as shown in the second column of Chart 1. Government spending—which in the GDP accounts is direct outlays for personal and goods and services and doesn’t include transfers like Social Security benefits—has actually declined. Federal outlays fell 0.4% despite massive stimuli since most of it went to welfare and other transfers to state governments. But state and local spending dropped 0.9% due to budget constraints.



Residential construction accounted for 9% of the gain in the economy. This exceeds its share of GDP, but still is small since volatile housing normally leaps in recoveries, spurred by low interest rates. But deterrents abound. The initial boost to the economy as retrenching consumers cut imports was later reversed. So net exports reduced real GDP growth by 0.4% in the 13 quarters of recovery to date.

Inventory-building accounted for a substantial 19% of the rise in real GDP, suggesting the accumulation of undesired stocks since anticipation of future demand has been consistently subdued. Nonresidential structures fell 0.1% as previous overbuilding left excess space. Equipment spending contributed 20% of the overall growth, but has failed to shoulder the normal late recovery burst.

Nevertheless, the small intellectual property products component, earlier called software, accounted for 5% of overall growth compared to its 3.9% share of GDP. This reflects the productivity-enhancing investments American business have been using to propel profit margins and the bottom line in an era when sales volume has been weak and pricing power absent.

As we predicted over three years ago in our book The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, and in many Insights since then, economic growth of about 2% annually will probably persist until deleveraging, especially in the financial sector globally and among U.S. consumers, is completed in another four or five years. Deleveraging after a major leveraging binge and the financial crisis that inevitably follows normally takes around a decade, and since the workdown of excess debt commenced in 2008, the process is now about half over. The power of this private sector deleveraging is shown by the fact that even with the immense fiscal stimuli earlier and ongoing massive monetary expansion, real growth has only averaged 2.3% compared to 3.4% in the post-World War II era before the 2007-2009 Great Recession.

Optimists, of course, continue to look for reasons why rapid growth is just around the corner, and their latest ploy is the hope that the effects of individual income tax hikes and reduced federal spending this year via sequestration have about run their course. Early this year when these negative effects on spending were supposed to take place, scare-mongers in and out of Washington predicted drastic negative effects on the economy. But federal bureaucrats apparently mitigated much of the effects of sequestration, and the income tax increases on the rich, as usual, didn’t change their spending habits much. So the positive influences on the economy as sequestration fades and income tax rates stabilize are likely to be equally minimal.

Furthermore, small-business sentiment has fallen recently. The percentage of companies that look for economic improvement dropped from -2 in August to -10 in September and -17 in October to a seven-month low. Those expecting higher sales declined from +8 to +2 in October. Most of the other components of the index fell, including those related to the investment climate, hiring plans, capital spending intentions, inventories, inflation expectations and plans to raise wages and prices. Other recent measures of subdued economic activity include the New York Fed’s survey of manufacturing and business conditions and industrial production nationwide, which fell 0.1% in October from September.

The New York Fed’s Empire State manufacturing survey index for November fell to 2.21%, the first negative reading since May. Every component dropped—orders, shipments, inventories, backlogs, employment, the workweek, vendor performance and inflation.

Global Slow Growth

The ongoing sluggish growth in the U.S. is indeed a global problem. It’s true in the eurozone, the U.K., Japan and China. Recently, the International Monetary Fund, in its sixth consecutive downward revision, cut its global growth forecast for this year by 0.3 percentage points to 2.9% and for 2014, by 0.2 percentage points to 3.6%.

It lowered its 2013 forecast for India from 5.6% to 3.8%, for Brazil from 3.2% to 2.5% and more than halved Mexico’s to 1.2%. For developing countries on average, the IMF reduced its 2013 growth forecast by 0.4 percentage points to 5%, citing the drying up of years of cheap liquidity, competitive constraints, infrastructure shortfalls and slowing investment. It also worries about their balance of payment woes. For 2014, the IMF chopped its growth forecast for China from 7.8% to 7.3% and from 2.8% to 2.6% for the U.S.

Fiscal Drag

Fed Chairman Bernanke continually worries about fiscal drag. Without question, the federal budget was stimulative in earlier years when tax cuts and massive spending in reaction to the Great Recession as well as weak corporate and individual tax collections pushed the annual deficit above $1 trillion. But the unwinding of the extra spending, income tax increases and sequestration this year and economic recovery—weak as it’s been—have reduced the deficit to $680 billion in fiscal 2013 that ended September 30.

From here on, the outlook is highly uncertain with persistent gridlock in Washington between Democrats and Republicans. So far, they’ve kicked the federal budget and debt limit cans down the road and they may do so again when temporary extensions expire early next year. It looks like many in Congress have no intention of resolving these two problems and may be jockeying for position ahead of the 2014, if not the 2016, elections.

In our many years of observing and talking to Congressmen, Senators and key Administration officials of both parties, it’s clear that Washington only acts when it has no alternative and faces excruciating pressure. A collapsing stock market always gets their attention, but the ongoing market rally, in effect, tells them that all is well or at least that it doesn’t require immediate action.

The Fed

With muted economic growth and risks on the downside, distrust in the abilities or willingness of Congress and the Administration to right the ship, and falling consumer and business confidence, the burden of stimulating the economy remains with the Fed. Janet Yellen, the likely next Chairman, seems even more committed than Bernanke to continuing to keep monetary policy loose. The Fed plans to reduce its buying of $85 billion per month in securities but the negative reactions by stocks (Chart 2), Treasury bonds (Chart 3) and many other securities to Bernanke’s hints in May and June that purchases would be tapered and eliminated by mid-2014 made a strong impression on the Fed. Similarly, the release of the minutes of the Fed’s October policy meeting— which again said officials looked forward to ending the bond-buying program “in coming months” if conditions warranted—resulted in an instant drop in stock and bond prices.

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The Fed is trying to figure out how to end security purchases without spiking interest rates, to the detriment of housing, other U.S. economic sectors and developing economies. It’s moving toward “forward guidance,” more commitment to keep the short-term interest rate it controls low than its present pledge to keep it essentially at zero until the current 7.3% unemployment rate drops to 6.5% and its inflation rate measure climbs to 2.5% from the current 1.2% year-over-year.

The hope is that a longer-term commitment to keep short-term rates low will retard long rates as well when the Fed tapers its asset purchases. This strategy appears to be having some success. Treasury investors are switching from 10-year and longer issues to 2-year or shorter notes. This is known as the yield-steepening trade as it pushes short-term yields down and longer yields up. As a result, the spread between 2-year and 10-year Treasury obligations has widened to 2.54 percentage points, the most since July 2011. Banks benefit from a steeper yield curve since they borrow short term and lend in long-term markets. But borrowers pay more for loans linked to long-term Treasury yields. There’s a close link between the yield on 10-year Treasury notes and the 30-year fixed rate on residential mortgages.

The Fed has already signaled that it may not wait to raise short rates until the unemployment rate, a very unreliable gauge of job conditions as we’ve explained in past Insights, drops below 6.5%. Bernanke recently said that “even after unemployment drops below 6.5%, the [Fed] can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.” At that point, the Fed will consider broader measures of the job market including the labor participation rate. If the participation rate hadn’t fallen from its February 2000 peak due to postwar baby retirements, discouraged job-seekers and youths who stayed in school since job opportunities dried up with the recession, the unemployment rate now would be 13%.

The Fed is well aware that other than pushing up stock prices, its asset-buying program is having little impact on the economy. In a recent speech, Bernanke said that while the Fed’s commitment to hold down interest rates and its asset purchases both are helping the economy, “we are somewhat less certain about the magnitude of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed’s balance sheet.” We wholeheartedly agree with this sentiment, as discussed in detail in our October Insight. Tapering Fed monthly purchases only reduces the ongoing additions to already-massive excess member bank reserves on deposit at the Fed.


Inflation has virtually disappeared. The Fed’s favorite measure of overall consumer prices, the Personal Consumption Expenditures Deflator excluding food and energy (Chart 4), is rising 1.2% year-over-year, well below the central bank’s 2.0% target and dangerously close to going negative.

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There are many ongoing deflationary forces in the world, including falling commodity prices, aging and declining populations globally, economic output well below potential, globalization of production, growing worldwide protectionism including competitive devaluation in Japan, declining real incomes, income polarization, declining union memberships, high unemployment and downward pressure on federal and state and local government spending.

With the running out of 2009 federal stimulus money and gas tax revenues declining as fewer miles are driven in more efficient cars, highway construction is declining and construction firms are consolidating and reducing bids on new work even if their costs are rising. Highway construction spending dropped 3.3% in the first eight months of 2013 compared to a year earlier. Also, states are shifting scarce money away from transportation and to education and health care. We’ve noted in past Insights that aggressive monetary and fiscal stimuli probably have delayed but not prevented chronic deflation in producer and consumer prices.

Why does the Fed clearly fear deflation? Steadily declining prices can induce buyers to wait for still-lower prices. So, excess capacity and inventories result and force prices lower. That confirms suspicions and encourages buyers to wait even further. Those deflationary expectations are partly responsible for the slow economic growth in Japan for two decades.

Low Interest Rates

With the Fed likely to continue to hold its federal funds rate close to zero, other short-term interest rates will probably remain there too. So the recent rally in Treasury bonds may well continue, with yields on the 10-year Treasury note, now 2.8%, dropping below 2% while the yield on our 32-year favorite, the 30-year Treasury “long bond,” falls from 3.9% to under 3%. Even-lower yields are in store if chronic deflation sets in as well it might. Ditto for the rise in stocks, which we continue to believe is driven predominantly by investor faith in the Fed, irrespective of modest economic growth at best. “Don’t fight the Fed,” is the stock bulls’ bellow. Supporting this enthusiasm has been the rise in corporate profits, but that strength has been almost solely due to leaping profit margins. Low economic growth has severely limited sales volume growth, and the absence of inflation has virtually eliminated pricing power. So businesses have cu t labor and other costs with a vengeance as the route to bottom line growth

Wall Street analysts expect this margin leap to persist. In the third quarter, S&P 500 profit margins at 9.6% were a record high but revenues rose only 2.7% from a year earlier. In the third quarter of 2014, they see S&P 500 net income jumping 14.9% from a year earlier on sales growth of only 4.7%. But profit margins have been flat at their peak level for seven quarters. And the risks appear on the downside.

Productivity growth engendered by labor cost-cutting and other means is no longer easy to come by, as it was in 2009 and 2010. Corporate spending on plant and equipment and other productivity-enhancing investments has fallen 16% from a year ago. Also, neither capital nor labor gets the upper hand indefinitely in a democracy, and compensation’s share of national income has been compressed as profit’s share leaped. In addition, corporate earnings are vulnerable to the further strengthening of the dollar, which reduces the value of exports and foreign earnings by U.S. multinationals as foreign currency receipts are translated to greenbacks.

Speculation Returns

Driven by the zeal for yield due to low interest rates and the rise in stock prices that has elevated the S&P 500 more than 160% from its March 2009 low, a degree of speculation has returned to equities. The VIX index, a measure of expected volatility, remains at very low levels (Chart 5). Individual investors are again putting money into U.S. equity mutual funds after years of withdrawals. “Frontier” equity markets are in vogue. They’re found in countries like Saudi Arabia, Nigeria and Romania that have much less-developed—and therefore risky—financial markets and economies than Brazil and Mexico.

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The IPO market has been hot this year. The median IPO has been priced at five times sales over the last 12 months, almost back to the six times level of 2007. And many IPOs have used the newly-raised funds to repay debt to their private equity backers, not to invest in business expansion. Through early November, IPOs raised $51 billion, the most since the $62 billion in the comparable period in 2000. Some 62% of IPOs this year are for money-losing companies, the most since the 1999-2000 dot com bubble. Some hedge fund managers are introducing “long only” funds with no hedges against potential stock price declines.

The S&P 500 index recently reached an all-time high but corrected for inflation, it remains in a secular bear market that started in 2000. This reflects the slow economic growth since then and the falling price-earnings ratio, and fits in with the long-term pattern of secular bull and bear markets, as discussed in detail in our May 2013 Insight.

High P/E

Furthermore, from a long-term perspective, the P/E on the S&P 500 at 24.5 is 48% above its long run average of 16.5 (Chart 6), and we’re strong believers in reversions to well-established trends, this one going back to 1881. The P/E developed by our friend and Nobel Prize winner, Robert Shiller of Yale, averages earnings over the last 10 years to iron out cyclical fluctuations. Also, since the P/E in the last two decades has been consistently above trend, it probably will be below 16.5 for a number of years to come.

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This index is trading at 19 times its companies’ earnings over the past 12 months, well above the 16 historic average. This year, about three-fourths of the rise in stock prices is due to the jump in P/Es, not corporate earnings growth. Even always-optimistic Wall Street analysts don’t expect this P/E expansion to persist in light of possible Fed tightening. Those folks, of course, are paid to be bullish and their track record proves it. Since 2000, stocks have returned 3.3% annually on average, but strategists forecast 10%. They predicted stock rises in every year and missed all four down years.


Residential construction is near and dear to the Fed’s heart. It’s a small sector but so volatile that it has huge cyclical impact on the economy. At its height in the third quarter of 2005, it accounted for 6.2% of GDP but fell to 2.5% in the third quarter of 2010 (Chart 7). That in itself constitutes a recession, even without the related decline in appliances, home furnishings and autos.

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Furthermore, the Fed can have a direct influence on housing. Monetary policy is a very blunt instrument. The central bank only can lower interest rates and buy securities and then hope the economy in general will be helped. In contrast, fiscal policy can aid the unemployed directly by raising unemployment benefits. But by buying securities, especially mortgage-related issues, the Fed can influence interest rates and help interest-sensitive housing. The rise in 30-year fixed mortgage rates of over one percentage point last spring probably has brought the housing recovery to at least a temporary halt. Each percentage point rate rise pushes up monthly principal and interest payments by about 10%.

Of course, many other factors besides mortgage rates affect housing and have been restraining influences. They include high downpayment requirements, stringent credit score levels, employment status and job security and the reality that for the first time since the 1930s, house prices have fallen—by a third at their low.

Capital Spending

Many hope that record levels of corporate cash and low borrowing costs will propel capital spending. And spending aimed at productivity enhancement, much of it on high-tech gear, has been robust as business concentrates on cost-cutting, as noted earlier. But the bulk of plant and equipment spending is driven by capacity utilization, and while it remains low, there’s little zeal for new outlays.

That’s why capital spending lags the economic cycle. Only after the economy strengthens in recoveries do utilization rates rise enough to spur surges in capital spending. And as our earlier research revealed, it’s the level of utilization, not the speed with which it’s rising, that drives plant and equipment outlays. So this is a Catch-22 situation. Until the economy accelerates and pushes up utilization rates, capital spending will remain subdued. But what will cause that economic growth spurt?

Government Spending

It’s unlikely to be government spending. State and local outlays used to be a steady 12% or so of GDP and a source of stable, well-paying jobs. But no more. State tax revenues are recovering (Chart 8), but the federal stimulus money enacted in 2009 has dried up, leaving many states with strained budgets.

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Pressure also comes from private sector workers who are increasingly aware that while their pay has been compressed by globalization and business cost-cutting, state and local employees have gotten their usual 3% to 4% annual increases and lush benefits. As a result, those government people have 45% higher pay than in the private sector, 33% more in wages and 73% in additional benefits. Oversized retiree obligations have sunk cities in California and Rhode Island and pushed Illinois to the brink of bankruptcy. Hopelessly-underfunded defined benefit pensions are a major threat to state and local government finances.

Municipal government employment is down 3.3% from its earlier peak compared to -0.2% for total payroll employment (Chart 9). And since these people are paid 1.45 times those in the private sector, two job losses is the equivalent of three private sector job cuts in terms of income. Real state and local outlays have fallen 9.5% since the third quarter of 2009.

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Federal direct spending on goods and services, excluding Social Security, Medicare and other transfers, has also been dropping, by 7.2% since the third quarter of 2010. Both defense and nondefense real outlays are dropping, and this has occurred largely before the 2013 sequestration. At the same time, federal government civilian employment, civilian and military, has dropped 6% from its top (Chart 10).

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U.S. Labor Markets

The U.S. labor market remains weak and of considerable concern to the Fed. Recent employment statistics have been muddled by the government’s 16-day shutdown in October and the impasse over the debt ceiling. Initially, 850,000 employees were furloughed although the Pentagon recalled most of its 350,000 civilian workers a week into the shutdown.

The unemployment rate has been falling, but because of the declining labor participation rate. We explored this phenomenon in detail in “How Tight Are Labor Markets?” (June 2013 Insight). As people age, their labor force participation rates tend to drop as they retire or otherwise leave the workforce. With the aging postwar babies, those born between 1946 and 1964, this has resulted in a downward trend in the overall participation rate—but it doesn’t account for all of the decline.

The irony is that participation rates of younger people tend to be higher than for seniors, but are declining. For 16-24-year-olds, the rate has declined sharply since 2000 as slow economic growth, limited jobs and rising unemployment rates have encouraged these youths to stay in school or otherwise avoid the labor force.

Meanwhile, the participation rates for those over 65 have climbed since the late 1990s as they are forced to work longer than they planned. Many have been notoriously poor savers and were devastated by the collapse in stocks in 2007-2009 after the 2000-2002 nosedive, two of only five drops of more than 40% in the S&P 500 since 1900.


An additional sign of job weakness is the large number of people who want to work full-time but are only offered part-time positions—”working part-time for economic reasons” is the Bureau of Labor Statistics term (Chart 11)—and these people total 8 million and constitute 5.6% of the employed. This obviously reflects employer caution and the zeal to contain costs since part-timers often don’t have the pension and other benefits enjoyed by full-time employees.

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This group will no doubt leap when Obamacare is fully implemented in 2015, according to its current schedule. Employers with 50 or more workers have to offer healthcare insurance, but not to those working less than 30 hours per week. When these people and those who have given up looking for jobs are added to the headline unemployment rate, the result, the BLS’s U-6 unemployment rate, leaped in the Great Recession and is still very high at 13.8% in October.

The weakness in the job market is amplified by the fact that most new jobs are in leisure and hospitality, retailing, fast food and other low-paying industries, which accounted for a third of the 204,000 new jobs in October. Manufacturing, which pays much more, has added some employees as activity rebounds but growth has been modest.

Real Pay Falling

With all the downward pressure on labor markets, real weekly wages are falling on balance. The folks on top of the income pile have recovered all their Great Recession setbacks and then some, on average. The rest, perhaps three-fourths of the population, believe they are—and probably still are—mired in recession due to declining real wages, still-depressed house prices, etc. Consequently, the share of total income by the top one-fifth, which has been rising since the data started in 1967, has jumped in recent years. The remaining four quintile shares continue to fall, although falling shares do not necessarily mean falling incomes.

The average household in the top 20% by income has seen that income rise 6% since 2008 in real terms and the top 5% of earners had an 8% jump. The middle quintile gained just 2% while the bottom 29% are still below their pre-recession peak. A study of household incomes over the 2002-2012 decade shows that the top 0.01% gained 76.2% in real terms but the bottom 90% lost 10.7%. In 2012, the top 1% by income got 19.3% of the total. The only year when their share was bigger was 1928 at 19.6%.

Real median household income, that of the household in the middle of the spectrum, continues to drop on balance, only leveling last year from 2011 (Chart 12). In 2012, it was down 8.3% from the prerecession 2007 level and off 9.1% from the 1999 all-time top. Americans may accept a declining share of income as long as their spending power is increasing, but that’s no longer true, a reality that President Obama plays to with his “fat cat bankers” and other remarks.

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Households earning $50,000 or more have become increasingly more confident, according to a monthly survey by RBC Capital Markets, but confidence among lower-income households stagnated, created a near-record gap between the two. Of the 2.3 million jobs added in the past year, 35% were in jobs paying, on average, below $20 per hour in industries such as retailing and leisure and hospitality. Since the recession ended, hourly wages for non-managers in the lowest-paying quarter of industries are up 6% but more than 12% in the top-paying quarter. These income disparities are reflected in consumer spending. In the first nine months of this year, sales of luxury cars were up 12% from a year earlier but small-car sales rose just 6.1%.

Consumer Spending

With housing, capital spending, government outlays and net exports unlikely to promote rapid economic growth in coming quarters, the only possible sparkplug is the consumer. Consumer outlays account for 69% of GDP, and with falling real wages and incomes, the only way for real consumer spending to rise is for their already-low saving rate to fall further.

Even the real wealth effect, the spur to spending due to rises in net worth, is now muted. In the past, it’s estimated that each $1 rise in equity value boosted consumer spending by three cents over the following 18 months while a dollar more in house value led to eight cents more in outlays. But now the numbers are two cents and five cents, respectively.

True, the ratio of monthly financing payments to their after-tax income has been falling for homeowners, freeing money for spending. Those obligations include monthly mortgage, credit card and auto loan and lease payments as well as property taxes and homeowner insurance. Nevertheless, for the third of households that rent, their average financial obligations ratio has been rising in the last two years as rents rise while vacancies drop.

Declining gasoline prices have given consumers extra money for other purchases, and are probably behind the recent rise in gas-guzzling pickup truck and SUV sales. Furthermore, the automatic Social Security benefit cost-of-living escalator will increase benefits by 1.5% in 2014 for 63 million recipients of retirement and disability payments. Still, with low inflation in 2013, the basing year, that increase is smaller than the 1.7% rise last year and the lowest since 2003, excluding 2010 and 2011 when there were no increases due to a lack of inflation. Social Security retirement checks will rise $19 per month to $1,294, on average, starting in January.

In any event, retail sales growth is running about 4% at annual rates recently, about half the earlier recovery strength (Chart 13). And a lot of this growth has been spurred by robust auto sales, allegedly driven by the need to replace aged vehicles.

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Insight readers know we’ve been waiting for a shock to remind equity investors of the fundamental weakness of the economy, and perhaps push the sluggish economy into a recession. With underlying real growth of only 2%, it won’t take much of a setback to do the job.

Will the negative effects of the government shutdown and debt ceiling standoff, coupled with the confusion caused by the rollout of Obamacare, be a sufficient shock? The initial Christmas retail selling season may tell the tale, and the risks are on the down side. Besides the consumer, we’re focused on corporate profits, which may not hold up in the face of persistently slow sales growth, no pricing power and increasing difficulty in raising profit margins.

Nevertheless, we are not forecasting a recession for now, but rather more of the same, dull, slack 2% real GDP growth as in the four-plus years of recovery to date.

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute…

Here’s the other side of the hedge fund debate that has been raging in recent weeks.  In case you haven’t been paying attention, a number of well known media outlets have published articles that have argued that hedge funds aren’t all they’re cracked up to be.  I’ve been pretty hard on hedge funds as well (see here) and firmly believe that hedge funds are largely replicating many of the poor trends seen in mutual funds.  That doesn’t mean all hedge funds are bad or that all mutual funds are bad, but as a general rule of thumb I think it’s safe to say that an index of hedge funds won’t add much value over a highly correlated index fund counterpart after you account for taxes, fees and other frictions.

Anyhow, dvegadtime was kind enough to let me republish his piece from last week which I think is extremely well thought out and certainly worth a read.  As always, feel free to use the comments to discuss.

Stop Investing In Hedge Funds Now! Oh No, Wait A Minute…

By dvegadtime:

“Don’t Invest in Hedge Funds” is probably the refrain you have been hearing and reading over and over again recently. The so-called “smart money” has been under attack as it has failed to beat the market and deliver juicy returns. Some hedge fund managers were harshly criticized because of their attacks on the FED and the monetary policies it has executed in recent years. While the reasons for their hatred towards Bernanke could originate from their trading positions (as Brad DeLong explained in this post) we should bear in mind that one size does not fit all. Blaming the hedge fund category as a whole is not only wrong, but silly.

First of all, accurately quantifying the returns of hedge funds is very hard, if not impossible. For the simple reason that, the large majority of them do not disclose their performances to the public. Matthew O’Brien, in his latest piece for the Atlantic, used a performance chart looking over only ten years and the HFRX index as if this is an index of hedge funds (like the S&P 500 for stocks for example). But that’s wrong. The HFRX shows the return of an index that attempts to track broad hedge-fund performances through the most diffused hedge fund strategies. Several indices which track hedge funds strategies have been constructed to try to replicate their performances. But this is not an easy task! With a lot of limitations. Robert Frey (Professor at Stony Brook University) and myself, find the EDHEC index much more representative than the HFRX. The EDHEC index takes into account the high fees (1% fixed fee of all assets, 10% of all profits), which have been heavily criticized. This finds Matthew and myself in agreement. If we take a look at the cumulative return over the 2000-2013 time window we can see that:

EDHEC file

Chart 1 – Courtesy of Robert Frey

And if we enlarge a little bit the time horizon, here is how the hedge fund performances look like:


Chart 2 – KPMG, AIMA, Centre for Hedge Funds Research

It seems like hedge funds have performed pretty well over a longer period of time. The two charts emphasize the big losses hedge funds incurred during the financial crisis. From Chart 1, we can also see that hedge funds have recently struggled a little bit to generate “abnormal” returns against the S&P 500. One could say “but it does not tell me anything about the risk taken by the industry, performances are not risk-adjusted” and this is of course a reasonable objection. However, it is almost impossible to measure the risk-adjusted returns of hedge funds because any measure of risk-adjusted returns is hocus pocus. Hedge funds have quantitative and qualitative risks that make them unique to evaluate and analyze. Someone else could say “An equally split (50%-50%) stock/bond hedge fund would have done better than the 60%-40% stock/bond portfolio”. Reasonable too. Objections can be many! But let’s focus for a moment on the recent performances. Hedge funds lost a lot of money during the crisis and let’s admit that they haven’t been able to beat the market recently. Are those good excuses not to invest in hedge funds? In my opinion no, and here is why.

We are missing three very important points here:

1. Hedge Funds provide diversification. Investment strategies of hedge funds vary vastly. To list a few: directional strategies, market-neutral strategies, equity long/short strategies, event driven funds, macro strategies, fixed income arbitrage, short bias etc. A lot of hedge funds try to achieve positive returns using strategies that move in the opposite direction of the major market indices. They therefore suit perfectly for diversification purposes. Risk, the premier journal for risk managers, found that 10 to 15 hedge funds are needed for optimum portfolio diversification:



2. Hedge funds can improve an investor’s overall return. It’s pretty common to think of hedge funds as risky bets. But hedge funds can be used for several purposes. There are in fact, low-volatility hedge funds that can enhance returns at limited costs. Or alternatively, returns can be boosted by using hedge funds that particularly focus on high-return strategies by trading volatile products. Generally speaking, investors look at hedge funds as dynamic and flexible investment vehicles able to be traded under several market circumstances. And when implemented in a portfolio with proper due diligence and awareness of the risks involved, benefits may be several.


KPMG, AIMA, Centre for Hedge Funds Research

3. Continued interest in hedge funds has never diminished, regardless of the recent negative performances and the adverse articles on the media. The asset under management stands at around $2.375 trillion. Compared to the $100,000 first investment in the first hedge fund under Alfred Winslow Jones in 1949, that should equate to a 30.39% annualized growth rate in AUM. If hedge funds have had such a high growth rate, it would indicate much better performance over time (see Chart 2), especially given the fact that they haven’t been able to, historically speaking, advertise. Prequin data shows that 60% of institutional investors, primary source of capital for hedge funds stated in 2013 that they are looking to increase their hedge fund allocation. And this should not be surprising, given the current macroeconomic environment and how hysterically investors have looked for yield in the last year or so. Investors, in fact, are getting prepared for both growth and volatility and use hedge funds as a way to access “dynamic and interconnected markets and to mitigate the risk inherent in these exposures”. Like in point 2, the flexibility of these instruments is something that investors demand.

One big problem for the industry as whole, now that some hedge funds will be able to advertise themselves, may be the pollution coming from people who are largely incompetent, crooks, or whoever does not use the most up-to-date financial tools. An investor should be able to pick the good hedge funds. Investing in hedge funds because something is called “hedge fund” should be strongly avoided. And this is easier said than done.  An investor carries together with the trade its own risk attitude as well as its own grade of financial sophistication, with a trade-off between the two.

Dreaming double figures returns is easy. Finding ways to systematically trade is harder.

Taking Matthew O’Brien’s paradox to the extreme, what’s worse? Rich people blowing money in hedge funds that are highly inaccessible to retail investors or the same retail investors being harmed by mutual funds that take fees from them but don’t deliver alpha?

John Thain: 2008 Could Happen All Over Again

Via Bloomberg Television:

John Thain, former chairman and CEO of Merrill Lynch and COO at Goldman Sachs, told Bloomberg Television’s Erik Schatzker and Sara Eisen on “Market Makers” today that a crisis like the one in 2008 could “absolutely” happen again.” Thain said, “If anything, too big to fail is a bigger problem because the biggest financial institutions are more concentrated today than they were. Dodd Frank did not solve too big to fail.”

Thain, who is currently CEO of CIT Group, also commented on selling the company to a larger bank, saying that would be “obvious.” He said, “The big banks are awash in deposits and they can’t generate attractive assets. We, in all our businesses, are able to generate very high-yielding, attractive assets, so the logic of that is obvious.”

Thain on how comfortable we should be with what Wall Street has become since September 2008:

“If you are asking about too big to fail and can what happened in 2008 could happen again, the answer is yes, it absolutely can happen again. If anything, too big to fail is a bigger problem because the biggest financial institutions are more concentrated today than they were. Dodd Frank did not solve too big to fail.”

On why there is so much resistance from the leaders on Wall Street re: too big to fail and why anyone would put the financial system and economy at risk again by being so large and complex:

“There are different things. They push back against parts of Dodd Frank because a lot of parts of Dodd Frank have nothing to do with the financial crisis or too big to fail. Proprietary trading was not the problem in the financial crisis. There are a lot of things in Dodd Frank that don’t help the too big to fail problem. The higher capital levels do help the too big to fail problem and make the failure much less likely. Higher capital levels are fine. But the regulatory burden and all of the rulemaking that goes inside of Dodd Frank, a lot of that is not helping.”

On whether he has any desire to go back to Wall Street to run one of the largest institutions:

“I’ve been at bigger companies and I’ve been at smaller companies. The New York Stock Exchange was a relatively smaller company especially when I started. I enjoy the challenge of fixing things, whether it was Merrill Lynch, which was certainly broken when I got there, or the NYSE or CIT, it has been fun to take companies that have good core businesses that have been damaged by the prior management and fix them.”

On how Merrill Lynch today compares to the firm that it was:

“I regret having to sell Merrill Lynch because it was a great company with a great history. It had a very good culture, but in the environment we were in, it was not likely to survive. It was necessary to protect shareholders and employees.”

On whether firms like Merrill Lynch survive and thrive inside the global universal banking model differently than when they were independent:

“Merrill was already pretty broad in its businesses. It would have been better if it could stay independent. Right now it’s contributing a significant portion of Bank of America’s overall earnings, given the problems in BofA’s other business, but I think it would have been better for the company if it remained independent.”

On how Goldman Sachs is doing coming out of the crisis and trying to restore its reputation:

“I think they are doing very well. One of the things is they have gotten through the crisis in relatively good financial shape. If anything, there’s less competition for them now. I actually think they are doing fine.”

On whether he feels any sense of loyalty to the firms he used to work for:

“I worked at Goldman Sachs for 25 years. I basically grew up there. You can’t help but feel loyalty there. The New York Stock Exchange was a great place to work. I enjoyed that job a lot. I got to be on TV more. That was a big turnaround. When I left, it was in much better shape and a global player. Merrill – I wasn’t there that long, but it was a great company. I do feel an affinity to all of those places.” 

On how far along CIT is in its transformation:

“When I started at CIT, there was a tremendous amount to do. It’s basically completed — the repairing of the damage coming out of the bankruptcy. The last piece was the lifting of the written agreement by the Federal Reserve. We got that a week or so ago…it is also a symbol of the fact that we are now a bank and bank holding company that’s in good standing with all of our regulators and we are now really focused on growing our business going forward.”

On whether CIT is still in restructuring mode and whether the company will have to announce more layoffs:

“We have been bringing our expense structure down. One of the things I had to do when I first started was to shrink the company. We had to get rid of the bad assets around the balance sheet and we refinanced $31 billion of debt. We are rationalizing some of our businesses. Our expenses are a little bit too high, we are working on bringing those down, but we are also working on growing assets.”

On how big he’d like the CIT bank to be and how much of its funding should be deposit based:

“Funding was absolutely one of the first challenges. Just to give an idea, on the day I started, our senior debt paid LIBOR plus 10 with a three percent floor. So you have a commercial finance company in this rate environment trying to make money with 13% debt. That’s basically impossible. We have refinanced or repaid all $31 billion of debt that came out of the bankruptcy. The other thing we have been doing is putting almost all of our new U.S. assets in our bank. We have a Utah bank that is FDIC regulated. It has been growing very nicely. We put all of those U.S. assets in there and we now have almost a third of our overall funding coming of that bank.”

On whether he’s been approached for a takeover:

“We would not talk about that on the air or anywhere else. I get asked this question a lot. If you look at the environment, the big banks are awash in deposits and cannot generate attractive assets. We and all of our businesses are able to generate high-yielding, attractive assets. The logic of that is obvious, but we are doing well I ourselves.”

On whether he would have to do right by shareholders if presented with an opportunity such as what happened with Merrill Lynch:

“I think I have a good track record of doing right by shareholders. I know who I work for.”

On the prospects for the universal banking model given the current regulatory environment:

“It’s a very normal thing, whatever you have a crisis, that there’s an overreaction to the crisis and an attempt to say, we’ll we’re going to make sure that this never happens again. If you look over many bubbles, this is the same thing that happened after the last bubble. The biggest issue right now for big global banks is the combination of higher capital standards, which is probably a good thing, but then excessive amounts of regulation in terms of their business. You don’t really need to have both. If you have significantly higher capital standards, than a lot of the regulatory burden that comes out of Dodd Frank is an overreaction.”

On the market conditions and whether we’re in store for another 1994:

“It’s hard to know…I think there’s no question that rates will go up and they will go up over time. It’s just a question of when and how violently. I’m less worried than sometimes the market seems to be about the Fed slowing down their purchases because I think they can slow down their purchases and still maintain their balance sheet and not adversely disrupt the market.”

On whether he’s worried about the impact it will have across the banking sector:

“No actually, such low rates actually makes it difficult for the banking sector because it’s hard to generate assets with yield. If interest rates were generally higher, I think that would help the financial sector. It would help us. We are asset sensitive. Our assets would re-price faster than our liabilities, so a higher rate environment would actually help our business.”

Hulbert Gold Sentiment at Record Lows

By Tiho, Short Side of Long

If you are sick and tired of reading Precious Metals sentiment updates on this blog, I do not blame you. As an author of a contrarian blog, my job is to report as an objective view as possible of sentiment indicators developing within the various asset classes. Right now, it seems that Gold is one of the few assets experiencing negative extremes worthy of attention, from a contrarian point of view. However, some of the readers disagree. Due to overwhelming focus towards the PMs sector in recent weeks, various individuals seem to think that I have turned into a die-hard Gold Bug. Obviously this couldn’t be further from the truth. Let me explain.

Within similar context, between August 2011 and November 2011, readers of the blog also held a view that I was a perma-bull on equities. If one was to consider previous posts hereherehereherehere and here, one should understand today (in hindsight) why I pushed major attention towards stocks over other asset classes. Stocks were extremely oversold and sentiment was extremely depressed between August and November 2011. Furthermore, on relative basis, global equities were very attractive against Precious Metals, Commodities and Bonds.

However, conditions have changed since those days. Stocks, particularly in the United States, have experienced a tremendous rally over the last two years. From the lows on 04th of October 2011 at 1075 on the S&P, the index is currently up over 45% and has become extremely overbought. At the same time, margins have started to contract and revenues/earnings are also following. As majority of the investors have missed the rally, they are not paying attention to fundamentals as greed blinds their judgement. They seem to be playing the usual chasing game over the last several weeks, with sentiment obviously turning extremely euphoric.

Furthermore, over that time frame, US equities have outperformed just about every other asset class out there, including Eurozone and Emerging Market equities, Precious Metals, Commodities and Bonds. Marc Faber recently described the current conditions stating that: “US equities have become the only game in town”. And we should all know how previous “only games in town” ended (in tears).

As I analyse the current market conditions, one of the only asset classes I tend to prefer today is the Precious Metals sector. I recent weeks I have hinted at the extremely depressed sentiment including the following important indicators:

  • In early March COT reported Gold short positions reached the highest level in over a decade
  • In early March Gold’s Public Opinion reached one of the lowest levels in at least a decade
  • Last week COT reported Silver short positions reached the highest level in almost two decades
  • Last week Silver’s Public Opinion reached one of the lowest levels in at least a decade


Source: Short Side of Long

The latest development worthy of “decade extreme” or “record extreme” within the Precious Metals sector, comes to us thanks to Mark Hulbert Financial Digest. According to Mark’s latest WSJ column, there has been a huge plunge in exposure of various Gold newsletter advisors. Currently, the Hulbert Gold Newsletter Sentiment index (HGNSI) is at -31% net short, a historical record low since the inception of the survey in 1997. Essentially, this means that the average Gold newsletter advisor is telling subscribers and various other clients to be short Gold with 31% of their portfolio.

As a side note, I would also like to remind blog readers that Hulbert Nasdaq Newsletter Sentiment index (HNNSI) is currently sitting at 94% net long exposure, equalling the euphoric sentiment of March 2000 just as the tech bubble topped.


Source: Short Side of Long<

All of these indicator readings mentioned above, added to the fact that just about every investment bank in the world has Gold on a sell signal, most likely suggest that we are approaching a meaningful low for the Gold and the rest of the sector.

Bottom Line

In Similar fashion to equities during August to November 2011, Precious metals have vastly under-performed just about all asset classes, including Stocks and Bonds. While sentiment has never been the holly grail (no indicator or tool is), current universally pessimistic outlook on the PMs sector is bound to end up as an egg on the face of various Wall Street strategists, advisors, financial gurus, newsletter writers, hedge fund managers, retail investors and other speculators.

Chart of the Day: Silver Shorts Surge

By Tiho, Short Side of Long

Today’s chart refocuses on the precious metal sector and in particular investor positioning towards Silver. Hedge funds and other speculators are now so negative on the metal, that the short positions have reached the highest level in the last 17 years (possibly even longer).

So what does this mean?

Judging by the historical price action over the last two decades, whenever speculators have held such enormous bearish positions, the price of Silver was either at or near a major low. Consider the following:

  • As short bets reached 44,790 in 1997, a huge short squeeze doubled the price in coming months
  • In 2000 and 2001 short bets reached over 44,000 triggering the start of a secular bull market
  • Finally, short bets reached 45,163 in 2005 as Silver broke out, rallying for almost three years

Silver COT

Guest Post: “Sell American. I am.”

By Ben Michaud, Private Investor (originally posted on Zero Sum)

To borrow from Buffett’s 2008 op-ed, “Buy American. I Am.”, the title of my presentation is….


In summary, the bullish case for stocks as peddled by David Tepper earlier this year is as follows:

1. Stocks are cheap relative to bonds with 2014 operating earnings yield of 7.5% versus a 1.93% 10-Year US Treasury yield
2. Central banks have removed tail risk from the system – most specifically with Draghi’s “Whatever it takes” commentary in July 2012
3. The Fed’s current QE program puts a floor under equity markets – i.e. a free put, akin to the “Greenspan Put”

Just like many value investors on this forum, I’m a valuation guy – in the long-run, little else matters. At a recent price level of 1,557, the S&P 500 is projected to return 3.87% per annum over the following ten years. If we subtract the 10-year treasury yield of 1.93%, we get the so-called “market risk premium”, which is 1.94% at present. I’m going to go out on a limb and say the bull case as outlined above is currently priced into stocks.

Compare the current MRP of 1.94% to the MRP at 10/15/08, the night before Buffett penned his “Buy American. I Am.” op-ed in the New York Times…..5.89%. That was with a 4.04% 10-year treasury yield. The current MRP is with a 1.93% yield!!!! To say the least, I am VERY fearful right now with so much greed in the market.

History is fraught examples of why valuation metrics are not great “timing” metrics – look no further than GMO and Baupost sitting out a massive bull run from 1996 through 2000 (off the top of my head). If so, why do I think NOW is the “time” to short the market? Well in addition to being a valuation guy, I’m also a market guy – I’ve tried, but I am unable to plug my nose and ignore two facts: the market moves in long secular valuation cycles and the crowd is ALWAYS wrong at extremes. Thus, I like to view the risk-reward of the market with a multi-faceted approach, and not JUST valuation. So in summary conclusion, I believe the market at current levels presents an attractive asymetric short opportunity for the following reasons:

1. S&P 500 approximately 49% overvalued
2. U.S. secular bear market likely still in progress
3. Extreme optimism among fund managers with long exposure at multi-year highs

The trade has a 3.85 year duration and a projected IRR of 15.5% per annum from a recent SPX level of 1,557.
Please refer to the attached presentation for a detailed outline of the thesis.

***A note on market timing – When I say “timing”, it is not in the typical derogatory way that “market timing” critics use it – rather, I mean timing of the risk-reward equation. In other words, one can never know precisely when the market will decline, BUT one can determine the “time” the risk-reward equation is as such that the market does not sustainably rise above a particular level. For example, the market never fell back to its 1996 level of between 600 and 700 in the 2000-2002 bear market – so if you were bearish in 1996, your short position never even broke even in the decline you were ultimately looking for.***

See the full presentation here.  

Is the Lack of Bearish Sentiment Bearish?

By Tiho, Short Side of Long

It has been awhile since I discussed equity market sentiment and that is because not much has changed. Bulls continue to get more bullish, the sun is shining and everyone is singing “Kumbaya my lord“. It is worth noting that overly optimistic readings we saw earlier in the year have put a stop to a rally in variety of risk assets, including:

Eurozone Equities & Emerging Markets
European Euro & Canadian Dollar
High Grade Copper & Brent Crude Oil

Therefore, if you live outside of US, your local equity market has most likely already started to decline. On the other hand, to everyone’s amazement, the US equity market has continued to rise all on its own in vertical fashion and therefore deserves a nickname “Teflon Rally”. But can the S&P 500 stay bullet proof all on its own?

I personally doubt it. I have been bearish on the equity markets since the later parts of 2012 and yet the rally continues higher, so I won’t blame you if you are sick and tired of hearing me warn about the potential sell off.

Nevertheless, all of the warnings remain in place and sentiment conditions continue to worse (indicators point to a contrary outcome). The latest sentiment update will be arriving later on today (early morning US time), courtesy of Investor Intelligence, so I thought it would be nice to include it as today’s chart of the day. Chart 1 shows that the current level of bearish advisors has fallen to alarmingly low levels, commonly linked to major market peaks. A quick glance at the chart shows similar readings in 2007, 2010, 2011 and presently.

One of the recent Merrill Lynch research notes I received in my inbox actually discussed the same sentiment conditions, so it is worth sharing. The table above shows a two decade historical study of Investor Intelligence bearish readings relative to the equity market performance. The study assumes that when bearish readings fall below 25%, equities are considered to be overbought.

From the data above, we can make a few interesting observations:

1)  The current duration of complacency seems to be the longest in two decades and has also registered the lowest reading of all the previous conditions.
2)  Apart from the tech euphoria of 1998, the equity market tends to peak within a few days to a few weeks after extreme bearish readings occur.
3)  The average and median decline following such a streak of complacent readings by II Bears indicates a high possibility of a bear market (20% decline from peak to trough).

Cyprus: The Next Blunder

By Charles Wyplosz, Professor of International Economics, Graduate Institute, Geneva (Via VOX)

The decision to tax all Cypriot bank deposits has attracted massive attention (Spiegel 2013) – and rightly so. It is a huge blunder:

  • In the unlikely event that all goes well, the government will receive a bit of cash – but not enough to cover the loan generously offered by its European partners – and the Cypriot banking system will be history.
  • The alternative is a massive bank crisis in many Eurozone countries – a huge blow to the euro, maybe even a fatal one.

Not an emergency measure

Policymakers have been debating the Cyprus’s bailout for nearly a year; this cannot be classified an “emergency action”. They engaged in a lively debate whether Cyprus is “systemic” or not, the answer to which can only be “it depends”. It depends not on the size of Cypriot banks but on the way the Eurozone acts. They also debated the Russian deposits that apparently represent a sizeable proportion of bank liabilities. The debate turned around the issues of how dirty this money is and how to do the laundry. They also debated on the size of a possible loan to the Cypriot government. The government itself requested something to the tune of 100% of its GDP, why not? After all this amounts to 0.2% of Eurozone GDP.

Eurozone’s help: Suffocating solidarity

From what is known:

  • Cyprus will receive a loan of about half the requested size under the usual austerity conditions.
  • The gross public debt of Cyprus will rise from its current level of some 90% of GDP to about 140%, a level that is unsustainable and will eventually require some deep restructuring.

This debt trajectory is a forecast, of course, but well in line with experience.

The effects of this Eurozone austerity programme are now well known. Cyprus joins a distinguished list of countries that benefit from suffocating Eurozone solidarity (Wyplosz, 2011).

  • The programme will impose tough austerity;
  • Its public-debt-to-GDP ratio will grow because deficits will not go away and because GDP will decline.
  • There will the need for more loans as economic predictions will be found to be “disappointing” over and over again.
  • Unemployment will skyrocket, spreading intense economic and social suffering.

Who knows, populist parties could well be on the rise, adding political drama to economic pain. This technology is now well oiled.

The bank deposit ‘confiscation’

What is new is that bank deposits will be “taxed”. The proper term is “confiscated”. Like everywhere in the EU, bank deposits in Cyprus are guaranteed up to €100,000. Depositors have arranged their wealth accordingly, only to be told that the guarantee has been changed ex post.

Taxing stocks is optimally time-inconsistent (Kydland and Prescott, 1977). It is a great way of raising money but it has deep incentive effects as it destroys property rights. What is at stake is the credibility of the bank deposit guarantee system throughout Europe.

The system was shaken in 2008 but in the opposite direction. Followed by all other countries, Ireland offered a full guarantee in a successful effort to stem an impending bank run. The cost to the government was such that it triggered a run on the public debt that led to the second bailout after the Greek “unique and exceptional” one.

That move has now been recognised as a mistake, which may explain how Cyprus is now being treated.

The Eurozone’s ‘corralito’

Because it is time-inconsistent, the decision to tax deposits has been preceded by a freezing of bank deposits. This is remindful of the Argentinean corralito of 2001, which led to economic dislocation, immense suffering and such anger that two governments fell (Cavallo 2011). Hopefully, the Cypriot corralito will not last too long.

The question is: “how bank depositors will react in Cyprus and elsewhere?” The short answer is that we don’t know but we can build scenarios:

  • The benign scenario is that depositors in Cypriot banks will accept the tax and keep their remaining money where it is. Depositors in other troubled countries will accept that Cyprus is special and remain unmoved.
  • A less benign scenario is that depositors in Cypriot banks come to fear another round of optimal, time-inconsistent levies. This is what theory predicts. After all, if policy makers found it optimal once, why not twice, or more?

Under the less benign scenario:

  • We will have a full-fledged bank run as soon as the corralito is lifted. Since bank assets amount to some 900% of GDP, there is no hope of any bailout by the Cypriot government.
  • Any new European loan would immediately translate into a run on the public debt.

Enter ECB, stage right

At this point in the scenario script, the ECB enters the play. Being the only lender of last resort, the ECB will have to decide what to do.

  • In principle, it could stabilise the situation at little cost as total Cypriot bank assets represent less than 0.2% of Eurozone GDP or 0.5% of the central bank’s own balance sheet.
  • But this would involve the risk that it could suffer losses – especially if the banks are badly resolved, i.e. the bankruptcies are badly handled.

This is not unlikely since the ECB does not control Cypriot bank resolution.

Remember that the current version of the banking union explicitly leaves resolution authority in national hands. In Cyprus, as almost everywhere else, national authorities are deeply conflicted when it comes to their banking systems. Powerful special interest groups become engaged when banks go bust and governments decide who pays the price. Thus, it is a good bet that Cyprus’s bank resolution will be deeply flawed. The risk to the ECB is real.

Proper resolution under European control could have been part of the conditions for the loan just agreed. But this does not seem be the case. The omission most likely reflects a belief by policymakers that the Cyprus crisis has been solved successfully. The problem is that this belief is false: Cyprus’s predicament remains even under the benign scenario.

All the conditions for a total disaster are in place

The really worrisome scenario is that the Cypriot bailout becomes euro-systemic – in which case the collapse of the Cypriot economy will be a sideshow. This will happen when and if depositors in troubled countries, say Italy or Spain, take notice of how fellow depositors were treated in Cyprus.

All the ingredients of a self-fulfilling crisis are now in place:

  • It will be individually rational to withdraw deposits from local banks to avoid the remote probability of a confiscatory tax.
  • As depositors learn what others do and proceed to withdraw funds, a bank run will occur.
  • The banking system will collapse, requiring a Cyprus-style programme that will tax whatever is left in deposits, thus justifying the withdrawals.

This would probably be the end of the euro.


The likelihoods of these three scenarios – benign, less benign, and total disaster – are difficult to assess.

What is clear is that the Cyprus bailout has created a new situation, more perilous than ever before.
Once more a deeply dangerous policy action is decided apparently without any awareness of its unintended consequences.
It is also another violation of sound existing arrangements. We have a no-bail-out clause in the Maastricht Treaty – a clause that was essential to the Eurozone’s stability. Putting it aside in the case of Greece was the heart of the today’s problem – the reason the crisis spread (Wyplosz 2010). This no-bail-out clause has once again been put aside summarily.

We are now witnessing another radical change as a perfectly reasonable deposit guarantee is being undermined. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors.


Cavallo, Domingo (2011). “Looking at Greece in the Argentinean mirror”, VoxEU, 15 July 2011.

Kydland, F.E. and E.C. Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans”, Journal of Political Economy, 1977, 85(3): 473-491.

Spiegel, Peter (2013). “Cyprus depositors’ fate sealed in Berlin”,, March 17, 2013 6:23 pm.

Wyplosz, Charles (2010). “And now? A dark scenario”,, 3 May 2010,

Wyplosz, Charles (2011). “The R word”,, 29 April 2011.

Helicopter Money

Stephen Grenville, Visiting Fellow, Lowy Institute (via VOX)

Ideas about ‘printing money’ and ‘helicopter money’ are in vogue. This column unpacks these misleading terms and explores what quantitative easing and Overt Monetary Finance might mean for the deficit. The case for Overt Monetary Finance needs to be balanced by considering the distortions which quantitative easing – and, in fact, potentially Overt Monetary Finance itself – might have on bank balance sheets, as well as their potential to damage central-bank independence.

In the current debate about monetary policy, two terms are bandied about to the detriment of clarity: ‘printing money’ and ‘helicopter money’ (Sinn 2011).

Printing money

To describe quantitative easing as ‘printing money’ is a misnomer. The amount of currency held by the public is determined by demand. When the Bank of England carries out quantitative easing, it pays for the bonds by crediting the seller’s bank. There is an increase in base money in the form of bank deposits at the central bank, but the demand for currency hasn’t changed. There is no need to ‘print money’.

An individual bank with excess holdings of deposits at the Bank of England might try to reduce these by creating new credit or buying other assets. But whatever individual banks do, the total amount of base money remains unchanged.

Helicopter money

The image of the central-bank helicopter dropping currency onto the eager public below is even more misleading. Governments can do this, giving away either cash or, more realistically, cheques (the Australian government sent cheques to most taxpayers in 2009, dubbed the ‘cash splash’). But this is fiscal policy, not monetary policy. Central banks have no mandate to give money away (they can only exchange one asset for another, as they do in quantitative easing). Decisions like this are backed by the usual budget-approval process. Thus it is a government helicopter that does the drop, and it is called fiscal policy.

As usual, there are disagreements about how effective this would be in stimulating demand. Unless there is strong crowding-out or Ricardian equivalence – very unlikely when there is spare economic capacity and interest rates are held down by monetary policy – or, indeed, this deficit can’t be funded – clearly not currently applicable, with bond yields historically low – then this is very likely to boost demand. The recipient of the largess might save some, but will spend most. Thus those who explore this policy option are doubtless correct in arguing that fiscal expansion would provide a more assured boost to demand than would quantitative easing.

If there is a concern that normal funding through bond issuance might push up interest rates or that financial markets might baulk at the funding requirement, the central bank could fund the deficit, taking bonds into its balance sheet and crediting the government’s account. This is, to all intents and purposes, a quantitative easing operation, although it might be initiated by the government.

Funding the deficit

Who is bearing the cost of funding the budget deficit? When the government draws down its account at the central bank to write cheques to the public (the ‘cash splash’), these cheques are paid into banks. Even in the fantasy world of a helicopter currency drop, this ends up being deposited with banks, as the public already has all the currency it wants to hold. The banking system has more deposits from the public on its liability side, and more deposits with the central bank on the assets side. The deficit has been funded by forcing the banks to hold more base money.

Thus this approach doesn’t avoid an increase in official debt (the central bank’s increased liability to the banks has to be counted). Similarly, if the central bank pays a market interest rate on these deposits (which most central banks currently do), then it’s not even saving any funding cost. If the central bank ceases paying a market return on these deposits, that would lower the interest cost of funding the deficit, but it would be a de facto tax on banks.

There are subtle differences between this deficit-funding operation and normal quantitative easing. First, central banks decide when to do quantitative easing and how much, while an Overt Monetary Finance would be a joint decision with the government. This raises issues of central-bank independence: the ability to say ‘no’ to government requests for funding is an important discipline on budget expenditures. There may also be a different understanding in financial markets about the unwinding of this operation. The clear understanding is that quantitative easing will be unwound at some stage, while with Overt Monetary Finance this might be unclear (although the distortionary impact of the banking system’s forced holding of substantial excess reserves doesn’t seem to be a satisfactory long-term arrangement).

Lord Turner (2013) is right in criticising the inflation alarmists, who carry outdated views on the relationship between money and prices. Similarly, the ‘deficit-fetishers’ who argue that stimulus will be futile and harmful should be required to make their case within the current context of spare capacity. Lord Turner’s cautious case for Overt Monetary Finance needs to be balanced by considering the distortions which quantitative easing (and potentially Overt Monetary Finance) have on bank balance sheets, as well as the damage to central-bank independence.


Sinn, Hans-Werner (2011, “The threat to use the printing press”,, 18 November.

Turner, Adair (2013), “Debt, Money and Mephistopheles: How do we get out of this mess?”, speech, Cass Business School.

Have We Solved Too Big to Fail?

By Andrew Haldane, Bank of England (via VOXEU)


That is not my pessimistic verdict; it is the market’s. Prior to the crisis, the 29 largest global banks benefitted from just over one notch of uplift from the ratings agencies due to expectations of state support. Today, those same global leviathans benefit from around three notches of implied support. Expectations of state support have risen threefold since the crisis began.

This translates into a large implicit subsidy to the world’s biggest banks in the form of lower funding costs and higher profits. Prior to the crisis, this amounted to tens of billions of dollars each year. Today, it is hundreds of billions (Haldane 2012). In other words, if the market’s expectations are to be believed, the regulatory response to the crisis has not plugged the ‘too-big-to-fail’ sink.

On the face of it, that sounds perplexing. Rarely a day passes without a warning from the financial industry about overbearing regulation of, in particular, the world’s biggest banks. What is certainly true is that, in the light of the crisis, regulation to quell the too-big-to-fail problem has come thick and (at least in regulatory terms) fast. This reform effort falls into roughly three categories:

(a) Systemic surcharges: of additional capital levied on the world’s largest banks according to their size and connectivity. This Pigouvian tax on systemic risk externalities is built on conceptually sound foundations (for example, Brunnermeier 2009). And, encouragingly, good economics has found its way into good public policy. Last year, the Financial Stability Board (FSB) agreed a sliding scale of systemic surcharges for the world’s largest banks. The highest surcharge was set at 2.5% of capital.

Yet therein lies the problem. Based on my estimates (Haldane 2012), a charge levied at this rate would leave the majority of the systemic externalities associated with the world’s biggest banks untouched. The reduction in default probabilities associated with lowering leverage by a percentage point or two would not offset the higher system-wide loss-given-default associated with the world’s largest banks. The systemic tax is being levied at rates which are too low to meet Pigouvian ends.

(b) Resolution regimes: In principle, orderly resolution regimes for banks could lower the collateral costs of a big bank defaulting, thereby tackling at source these systemic externalities. And significant public policy progress has been made on this front, with the FSB publishing (and the G20 approving) some Key Attributes for Effective Resolution Regimes during the course of the past 18 months. A key component of these plans is the ability to impose losses on private creditors – so-called ‘bail-in’ – rather than have those losses borne by taxpayers.

As with systemic surcharges, the issue here is not to so much the bail-in principle, but its application in practice. Bail-in, whether of big banks, sovereigns or companies, faces an acute time-consistency problem. Policymakers face a trade-off between placing losses on a narrow set of tax-payers today (bail-in) or spreading that risk across a wider set of tax-payers today and tomorrow (bail-out).

A risk-averse, tax-smoothing government may tend towards the latter path – and historically has almost always done so, most notably in response to the present financial crisis. Next time may of course be different. But the market is sceptical. For example, in the US the Dodd-Frank Act on paper rules in future bail-in and rules out future bail-out. Yet market expectations of state support for US banks are higher today than before the crisis struck and are unchanged since Dodd-Frank became law. The time-consistency dilemma, at least in the eyes of markets, is as acute as ever.

(c) Structural reform: One way of lessening that dilemma may be to act on the scale and structure of banking directly. Several recent regulatory reform initiatives have sought to do just that, notably the “Volcker rule” in the US, the ‘Vickers proposals’ in the UK and, most recently, the ‘Liikanen plans’ in Europe. While different in detail, each of these proposals shares a common objective: a degree of separation or segregation between investment and commercial banking activities.

In principle, these ringfencing initiatives confer both ex-post (improved resolution) and ex-ante (improved risk management) benefits. Because they act on banking structure, they have a greater chance of proving time-consistent. While this is a clear step forward, those benefits are only as credible as the ringfence itself. The issue raised by some is whether, in practice, the ring-fence could prove permeable. Without care, today’s ring-fence could become tomorrow’s string vest.

If each of these initiatives is necessary but none is individually or collectively sufficient to tackle too-big-to-fail, what is to be done? One solution might lie in strengthening these proposals. For example, re-sizing the capital surcharge, perhaps in line with quantitative estimates of the ‘optimal’ capital ratio (Miles et al (2012), Admati et al (2011)), would be one option for bearing down further on systemic externalities.

Another more radical option, mooted recently by a number of commentators and policymakers, would be to place size limits on banks, either in relation to the financial system as a whole or, more coherently, relative to GDP (Hoenig (2012), Tarullo (2012)). Proposals of this type typically face two sets of criticism.

The first, practical issue is how to calibrate an appropriate limit. Recent research on the link between and financial depth and growth provides a way into this question. This research has suggested that there is a threshold at which the private-credit-to-GDP ratio may begin to have a negative impact on GDP and, in particular, productivity growth (Arcand et al (2012), Cechetti and Kharroubi (2012)). By taking a view on this aggregate threshold, and on an appropriate degree of concentration within the financial system, an institution-specific threshold could be derived.

The second, empirical issue is whether size limits would erode the economies of scale and scope which might otherwise be associated with big banks. The empirical literature on these economies has, until recently, suggested they may be exhausted at relatively low balance sheet thresholds. But a number of recent papers have painted a more optimistic picture, with economies of scale found for banks with balance sheets in excess of $1 trillion (Wheelock and Wilson (2012), Feng and Serilitis (2009), Hughes and Mester (2011)).

Yet this evidence needs to be interpreted cautiously, not least because it fails to recognise the implicit subsidies associated with too-big-to-fail. These would tend to lower funding costs and boost measured valued-added for the big banks. In other words, the implicit subsidy would show up as economies of scale. Bank of England research has recently shown that, once those subsidies are accounted for, evidence of scale economies for banks with assets in excess of $100 billion tends to disappear (Davies and Tracey (2012)). Indeed, if anything, there may even be evidence of scale diseconomies, perhaps consistent with big banks being ‘too big to manage’.

Too-big-to-fail is far from gone. It is even more important it is not forgotten. Further analytical work, weighing the costs and benefits of different structural reform proposals, would help keep memories fresh and policies on the right track.


Meaningful Banking Reform & Why it’s Unlikely to Happen

By Charles W Calomiris, Professor of Financial Institutions at the Columbia University Graduate School of Business (This article first appeared at Vox)

In the decades leading up to the recent banking crisis, regulators and supervisors consistently failed in three key areas:

  • They did not measure banks’ risks credibly or accurately, or set sufficient minimum equity capital buffers in accordance with those risks so that banks would be able to absorb potential portfolio losses reliably;
  • They failed to enforce the inadequate capital requirements they imposed because supervisors consistently failed to identify bank losses as they continued to mount, thus allowing banks to overstate their levels of capital;
  • They failed to design or enforce intervention protocols for timely resolution of the affairs of weakened banks to limit the exposure of taxpayers to protecting the liabilities of feeble, ‘too-big-to-fail’ banks.

The failures of prudential bank regulation have been visible for decades and have motivated many regulatory reform proposals by financial economists (den Haan 2012).

Solutions to regulators’ failures

There are credible solutions to the key policy challenges that the government faces. For the most part, my proposed solutions to those problems are not new; they have been known and advocated by financial economists for some time. The failure to prevent the crisis was not a failure of thinking, but a failure of will on the part of our political system. Our politicians and regulators have found it expedient to offer hidden subsidies for risk taking to bankers through the combination of safety net protection and ineffectual prudential regulation. Attempts to identify and rein in those subsidies have been defeated politically time and time again.

Will proposed reforms in response to the crisis be effective this time round? Will reformers succeed in implementing changes in the rules of the game that would reduce the chance of a repeat of the recent crisis? The experience with post-crisis reforms in financial history offers, at best, a mixed record of responses (see Calomiris 2010, 2011).

Overall, it is fair to say that there is much cause for pessimism for a simple reason: politicians don’t really have strong incentives to solve the problems of banking regulation; they have strong incentives to only pretend to do so.

Keeping up appearances

The typical post-crisis response gives the appearance of diligence, as politicians and regulators assemble a laundry list of the things that went wrong in the crisis – typically defined with reference to the specific symptoms of poor policies and not to the deeper incentive problems that policy errors have produced. That laundry list then gives rise to a new, more complex set of regulatory initiatives, and these laws and rules are advertised as preventing a recurrence of the problems.

Deficiencies are supposedly remedied by ever-more-complex sets of rules for measuring risk, by granting increased supervisory discretion to a variety of new government officials with varying mandates, by scores of new research initiatives pursued by increasingly fragmented research and supervisory divisions at central banks and supervisory agencies, by the creation of new international study groups. Is it too cynical to see this exponential increase in complexity of rules, and of the regulatory and supervisory authorities charged with designing and enforcing them, as deliberately designed to reduce accountability by dividing responsibility and by making the regulatory process less comprehensible to outsiders? I don’t think so.

The implicit theory behind these sorts of initiatives, to the extent that there is a theory, is that the recent crisis happened because regulatory standards were not quite complex enough, because the extensive discretionary authority of bank supervisors was not great enough, and because rules and regulations prohibiting or discouraging specific practices were not sufficiently extensive. That theory is demonstrably false. At the core of the recent financial crisis – and the many that preceded it around the world in the past three decades – have been basic incentive problems in the rules of the game set by the government. The pre-crisis environment was one in which regulatory complexity was unprecedented, supervisory enforcement was virtually non-existent, and private risk taking at public expense was virtually unlimited. And yet this is precisely the environment that has produced the most unstable 30 years in global banking history, and the most severe financial crisis in the US since the Great Depression.

What should the rules look like?

The need is not for more complex rules, and more supervisory discretion, but rather for rules that:

  • Are meaningful in measuring and limiting risk;
  • Are hard for market participants to circumvent;
  • Are credibly enforced by supervisors.

These qualities are best achieved by constructing simpler rules that are grounded in an understanding of the incentives of market participants and supervisors.

The keys to effective reform in all these categories are, first, recognising the core incentive problems that have encouraged excessive risk taking and ineffective prudential regulation and supervision, and, second, designing reforms that are ‘incentive-robust’ – that is, reforms that are likely not to be undermined by the self-seeking regulatory arbitrage of market participants, or the self-seeking avoidance of the recognition of problems by supervisors.

Proposed reforms

I have developed numerous specific incentive-robust reform proposals (for details see Calomiris 2013, Calomiris and Herring 2012). These include:

  • The reform of the regulatory use of ratings that would quantify the meaning of debt ratings and hold Nationally Recognized Statistical Rating Organizations (NRSROs) financially accountable for egregious inaccuracy in forecasting the probability of default of rated debts;
  • The use of loan interest rate spreads as forecasts of non-performing loans for purposes of budgeting capital to absorb loan default risk;
  • The establishment of a transparent and simple contingent capital (CoCo) requirement that incentivises large banks to replace lost capital in a timely way (rather than disguise losses and avoid replacing lost capital);
  • The setting of simple cash requirements for banks (this would not resemble the complicated and poorly conceived new ‘liquidity’ requirements created by the Basel III process);
  • The creation of a simple macro prudential rule to govern the variation in capital requirements over time and, which would trigger changes only under extreme circumstances, based on objective, observable criteria;
  • A reform of resolution procedures for large financial institutions that would require a pre-specified minimum haircut on unsecured creditors whenever the resolution authority employs taxpayer funds in the resolution (i.e. whenever there is a departure from the enforcement of strict priority in the resolution process);
  • The establishment, as part of the ‘living wills’ of global financial institutions that govern their prospective resolution, of clearly demarcated lines of legal and regulatory jurisdiction (‘ring fencing’) over the disposition of all the assets and liabilities within a bank.


This program of reform would be effective in addressing the real challenges that have threatened our financial system for decades, and continue to threaten it. And this approach would avoid much of the collateral damage that comes from the many hundreds of pages of complex, costly and misguided mandates that are typically substitutes for credible reform. Politicians, however, almost universally hate these sorts of simple ideas, based on observable criteria, precisely because they work by removing the discretionary control that politicians, bankers, and regulators enjoy and abuse over the enforcement of regulatory standards. Overcoming that challenge will require more than good economic thinking.


Calomiris, Charles W (2010), “The Political Lessons of Depression Era Banking Reform”, Oxford Review of Economic Policy, 26, Autumn, 540-560.

Calomiris, Charles W (2011), “Banking Crises and the Rules of the Game”, in Nicholas Crafts, Terry Mills, and Geoffrey Wood (eds.), Monetary and Banking History: Essays in Honour of Forrest Capie, Oxford, Routledge.

Calomiris, Charles W, “An Incentive-Robust Programme for Financial Reform”, Journal of Financial Perspectives, forthcoming.

Calomiris, Charles W, and Richard J Herring (2012), “Why and How to Design a Contingent Convertible Debt Requirement”, in Yasuyuki Fuchita, Richard J Herring, and Robert E Litan (eds.)Rocky Times: New Perspectives on Financial Stability, Brookings, 117-62.

Den Haan, Wouter (2012), “Banking reform: Do we know what has to be done?”,, 30 November.

Weekly Bull/Bear Recap: Turkey Week Edition

Here’s a good weekly summary via the RCS blog:

This objective report concisely summarizes important macro events over the past week.  It is not geared to push an agenda.  Impartiality is necessary to avoid costly psychological traps, which all investors are prone to, such as confirmation, conservatism, and endowment biases.


+ Uncertainty is decreasing.  In last week’s recap, the bull’s strongest case was the “the contours of a resolution” taking shape regarding the fiscal debate in Washington.  This week, more investors bought into this bullish point, leading to the S&P 500’s best weekly performance since June.   In geopolitical news, a cease fire has been declared in Gaza.  Decreasing conflict in the region means cooler heads are prevailing.

+ Risk markets are ripe for a tradable bullish move given that the S&P 500 is extremely cheap when looking at current P/E ratios.  In fact, it would need to rally 26% just to reach the average P/E of bull markets dating back since the 60s.  Meanwhile, trends in insider trading are hinting at a sustained rally to come.  Mainstream investors are entirely too pessimistic on longer-term earnings growth, yet sources of future growth are around us….

+ …global growth will be the recipient of a welcomed surprise in China, where a rebound is gaining strength as per HSBC’s latest PMI reading, increasing to 50.4 from 49.5 and marking the metric’s first expansionary reading in more than a year. Meanwhile, “The German economy is holding up well in face of the euro crisis” and ECB officials signal that the central bank is willing to forgo $9 billion in future profits on its Greek holdings, a sign of understanding that some relief will need to be given to periphery countries.

+ …meanwhile, U.S. economic growth will be increasingly supported by a rebounding housing market.  The National Assocation of Homebuilder’s Housing Index rises to a 6 and a half year high.  Existing home sales for October surprise to the upside and upward pressure in home prices may be the reason for improving consumer confidence (Source: Econoday).  Rising Housing Starts indicate that the housing industry is becoming more confident in the recovery.  Meanwhile in manufacturing, Markit’s U.S. PMI report certainly doesn’t agree with the bearish claim that the sector’s is about to enter contraction.  Finally, U.S. officials understand that today’s globalized economy is about competition and are considering establishing laws to encourage the brightest minds in the world to consider the U.S. as their home.



-Investors are like frogs in an increasingly hot investment environment.  Europe continues to show signs of disunity and infighting as EU finance ministers are unable to agree on a revised version of Greece’s fiscal consolidation plan or approve to extend the country’s public debt target.  Meanwhile France’s AAA rating is history as per Moody’s.  Increasing investor skepticism doesn’t bode well for lawmakers as eventually financial markets will force the issue.  Finally, economic and financial data is just awful.

– Confidence in the global recovery is evaporating.  U.S. Tech companies are feeling the effects of a slowing global economy.  Meanwhile, China reports that foreign investment in the country has fallen for 11 of the last 12 months.  If bulls are certain that China is poised to rebound, why has the Shanghai Index dropped to a new low?  Meanwhile, Japan reports a 6.5% plunge in October exports (exports to the EU cratered 20% YoY)

– As if critical damage due to a slowing global economy wasn’t enough, the U.S. economy is also contending with a crisis of confidence due to Fiscal cliff concerns.  Investment is falling off a cliff as companies pull back on business spending.  The consumer better step through this holiday season (early signs   aren’t promising).  Despite a higher trend in Michigan’s Consumer Sentiment index, weakening momentum is causing alarm.

– Cooler heads may seem to be prevailing in the Middle East, but the longer trend is of more hostility.  Meanwhile tensions in Asia remain elevated and territorial claims dealing with the South China Sea are likely to exacerbate fissures in the region.

The Era of Kakistocracy

Kakistocracy (noun): Government by the worst citizens. For reasons which can only be speculated upon, there is no word for government by the best citizens.1

We are now five years into a crisis that just doesn’t want to go away. Paraphrasing Charles Gave of GaveKal who wrote a supremely succinct paper on this topic only last week2, policy makers continue to tamper with interest rates, foreign exchange rates and asset prices in general. They continue to permit deposit-taking banks to operate like casinos. They issue new debt to pay for expenditures when we are already drowning in debt. They just don’t seem to get it. Albert Einstein once defined insanity as doing the same experiment over and over again, expecting a different result. QE1. QE2. QE3… Need I say more?

Meanwhile, more and more investors appear convinced that all this tinkering will end in inflation. Some even expect a lot of it. That is what this month’s Absolute Return Letter is about. Are bonds a safe investment at current levels? Could we possibly be in a bubble? In the tug-of-war between inflationary and deflationary forces, will inflation ultimately prevail? What could happen to bond prices if any of this comes to fruition?

Inflation vs. deflation               

I first wrote about inflation vs. deflation in July 2009 (see here). A lot has happened in the interim, suggesting that now is a good time to re-visit the subject. Let’s begin by establishing our fundamental position, which hasn’t changed much since 2009. Back then I concluded:

“If my worst fears are proven correct and we have to fight a bout of deflation, the authorities will have no choice but to try and provoke price increases through aggressive policy measures. Otherwise entire countries could be bankrupted as they suffocate in their own debt. Whether it will work is a different story.”

Three years on, I remain absolutely convinced that deflation, driven primarily by consumers eager to repair their balance sheets, will be a powerful force for many years to come but, at the same time, I must admit that I see worrying signs of inflation expectations beginning to creep in.

Now, before going any further, perhaps I should define inflation. Here it is appropriate to distinguish between asset price inflation and consumer price inflation. Most observers of financial markets would probably agree that, on balance, asset prices have benefitted from the combined actions of the world’s central banks over the past few years, so it seems fair to suggest that we already suffer from at least some degree of asset price inflation.

Consumer price inflation is a different beast altogether. The future path of consumer price inflation is to a large degree dictated by current inflation expectations. As is well established in economic theory, rising inflation expectations may change our behavioural patterns, which again may lead to a rise in actual inflation; hence inflation expectations are an important leading indicator of future inflation trends.

It is indeed possible to have asset price inflation without consumer price inflation and vice versa. Alternatively, the two types of inflation may also go hand in hand. What we are experiencing at the moment is a somewhat unusual combination. Asset price inflation in the ‘old’ world has led to consumer price inflation in emerging economies, mainly through rising commodity prices.

Having said that, there is no law of economics to suggest that the commodity price induced increase in consumer prices in emerging economies must ultimately lead to an increase in consumer prices in our part of the world. We don’t have to go more than 30 years back to find a prime example of very high consumer price inflation in one country (the United States) not leading to the same dramatic rise in consumer price inflation in one of its key trading partners (Western Europe).

More recently, the Federal Reserve Bank and, by implication, other central banks as well, have been heavily criticized for not delivering economic growth through QE. However, I am not at all convinced that economic growth is in fact the primary objective of QE. Bernanke is a life-long student of the Great Depression and understands deflation, and the damage it can inflict, better than most of us. If you go through his speeches and statements of recent years, there is plenty of evidence to suggest that he takes the risk of deflation very seriously, and his continuous commitment to QE is probably as much a reflection of those concerns as it is a policy that he realistically expects can accelerate economic growth.

Five possible paths

So, with that in mind, when will interest rates begin to rise outside of the European periphery? Many of those countries that enjoy record low interest rates today mainly do so because they have achieved safe haven status as the crisis along the Mediterranean coastline has deepened.

Financial history is littered with evidence that asset prices do not stay stable for long, so I feel very comfortable when I ask the loaded question when? Our analysis suggests that there are at least five possible paths which may lead to higher interest rates (conveniently ignoring some shorter term cyclical and technical reasons which won’t be part of this discussion):

  • The expansion of the balance sheets of the Fed, the BoE, the ECB and the SNB could ultimately lead to a rise in consumer price inflation in the U.S. and Western Europe.


  • Once central banks begin to shrink their balance sheets again, asset prices could come under pressure with interest rates going up as a result.


  • The crisis in the European periphery could spread to other countries as the true extent of the over-leverage becomes apparent (Japan, France, Belgium and Slovenia have all received regular mentions in the financial media).


  • The crisis in the European periphery could begin to abate, causing investors to pull out of the safe havens only to move back in to the periphery, causing spreads between the safe havens and the European periphery to narrow.


  • The crisis in the European periphery could linger on, but with the rest of the world paying less and less attention and hence, away from the crisis countries, some sort of normality could return with interest rates normalising, whatever ‘normal’ means these days.

(Please note that these outcomes are not necessarily mutually exclusive.)

Before I take a closer look at each of those five possible outcomes, I need to address a fallacy which will play an important role in the following. Many believe that sovereign de-leveraging is now well under way and that the austerity programmes put in place in various countries will begin to pay dividends soon. The reality is that governments have not even begun the de-leveraging yet!

Most so-called advanced countries (as defined by the IMF – I sometimes question how advanced these countries really are) are significantly more indebted today than they were in 2007, prior to the outbreak of the current crisis (chart 1).  The U.S. and Canada, most eurozone countries as well as the U.K. and Japan are all on that rather unflattering list.

Chart 1:  Cumulative Change in Gross Debt since Start of Recessions (% of GDP)

Source:     IMF Fiscal Monitor, October 2012.

The solid red line corresponds to 2009-12 and the dashed line to 2013-17.

There are several other interesting observations to take away from the chart above. Generally speaking, emerging economies have done a much better job than advanced economies in terms of controlling their debt during this crisis (bottom half of chart 1). Secondly, it is clear how outsized this crisis is relative to prior recessions (red line vs. shaded area in top half of chart 1). Finally, and most importantly, you can see how debt will continue to grow at least until 2015 (t+7), when the IMF expects debt-to-GDP to peak, following 7 years of debt accumulation. I will take almost any bet you put on the table that, bar a major sovereign restructuring and/or default between now and 2015, the IMF projection will prove too optimistic.

I should also mention that chart 1 refers exclusively to government debt. Corporate balance sheets outside the banking sector are generally speaking in good shape. Household balance sheets are a mixed bag but improving overall. Banks are a mess (chart 2).

Chart 2: Indebtedness and Leverage in Selected Countries

#1: Will QE lead to inflation?   

So, with that in mind, let’s go back to the five possible paths outlined above and ask the question: Will the monetary expansion ultimately lead to inflation? The simple answer is ‘not necessarily’. Since the Federal Reserve Bank embarked on QE, its balance sheet has grown by almost $2 trillion. This is money the Fed has paid out in exchange for the securities it has bought through the primary dealers3 in the U.S. market place.

The vast majority of the $2 trillion now sits in the reserve accounts that each of the primary dealers hold with the Fed. No new money has been printed as a result and, as long as the money stays in the reserve accounts, it will have zero effect on the broader economy and hence on inflation. Now, let’s assume that consumers and speculators regain their appetite for borrowing. It won’t be long before one or more of the primary dealers conclude that, with all those reserves, why not get back on the dance floor? Banks could possibly lend 8-10 times those reserves so, in principle, there is now almost $20 trillion in new lending capacity in the U.S. banking system as a result of the QE programme. (Similar calculations could be made for other countries.)

Now, that would be highly inflationary and it is precisely for that reason that many get scared by the possible implications of QE. However, there is one additional piece to the jigsaw which has not been revealed yet, and which is not widely understood. In 2008 a new law was passed in the U.S., permitting the Fed for the first time to pay interest on reserve accounts held with the Fed. With that new policy tool in hand, all the Fed would have to do would be to raise the interest paid on the reserve accounts to a level that would discourage reckless lending. For that reason alone, I believe the risk of runaway inflation as a result of the expansion of central banks’ balance sheets that we have witnessed in recent years is grossly exaggerated.

#2: When QE is reversed          

Now to the second possible path. The question is a simple one: Will rates rise when central banks begin to unwind the securities they have acquired in recent years? The answer is equally straightforward. Prior to 2008, the Fed would have had to eventually soak up the excess liquidity by selling those securities they had previously acquired. However, with the introduction of the new policy tool that came with the Reserve Remuneration Act of 2008, the Fed may never have to offload those securities again. In other words, interest rates may never be negatively affected because QE may never be reversed.

Having said that, market forces may drive interest rates higher, once investors conclude that there is no more QE coming. This may be true, even if already implemented QE programmes are never reversed. Chart 3 illustrates the enormous shift there has been in the last 5 years away from equities into bonds in global mutual funds. This shift is at least a part result of built-up frustration with equity returns. Yield hungry baby boomers may also have played a role as their fast approaching retirement has accelerated the search for income.

Chart 3:  Cumulative Flows to Global Mutual Funds (USD billion)

Source:   IMF Global Financial Stability Report, October 2012.

However, I believe a large part of the shift is driven by what can best be described as ‘chasing returns’. In comparison to the abysmal performance delivered by many equity funds in recent years, the fact sheets produced by most bond managers look irresistible to many investors. Perhaps they need reminding that past performance is not a guide to future performance?

#3: The debt crisis spreads       

The third path is what I usually refer to as the nightmare scenario. Instead of the crisis slowly abating, it actually spreads beyond the European periphery. Let’s take a look at Japan which is now more than 20 years into a seemingly never-ending recession. When the Japanese economy hit the wall around 1990, nobody expected it to fall into a 20+ year long trap of low growth, falling tax revenues and rapidly rising government debt (chart 4); however, a combination of bad policy decisions and unfavourable demographics, made worse by a strong currency, has made that happen.

Chart 4:  Japan’s Fiscal Nightmare

Source:   Goldman Sachs Global Economics Paper No 215, August 2012.

Following more than 20 years of dwindling tax revenues, Japan must issue more than ¥40 trillion worth of JGBs – more than a full year’s tax revenues – every year to fund the enormous gap between revenues and expenditures. With the 10-year yield at 0.77% that is just about affordable. Imagine what would happen if the bond vigilantes suddenly demanded 5% in annual interest from the Japanese government.

In a way, Japan was the luckier country, being 20 years ahead of everyone else. With the implementation of appropriate policies, they could have saved their own bacon; instead they made a royal mess of it. The rest of the world is less fortunate. There are too many countries in the boat that the Japanese have had for themselves for the past couple of decades, and the boat, regrettably, is taking in plenty of water at the moment. With the eurozone members caught up in a de facto gold standard, currency depreciation is no longer an option available to them. In fact, it is not really an option to anyone anymore, as every country is keen to export its way out of this crisis. Sadly, we cannot all export at the same time. The magic bullet has been lost.

In countries such as the U.S. and the U.K., approximately 10% of the government’s revenues are spent on interest payments on already existing debt. That is more or less where Japan was some 20 years ago. Japan should stand out to other governments as an example of how not to do crisis management. Instead our leaders seem hell bent on repeating the mistakes of Japan.

When a balance sheet is loaded with debt – whether sovereign, corporate or private – keeping the income flowing in must be priority number one. In the case of governments that translates to tax revenues. I have said it before and I’ll keep saying it ‘til the cows come home. Austerity kills growth. No growth, no tax revenues. Simple as that. Even the IMF has recently admitted that the so-called multiplier (which measures how much GDP you destroy by implementing $1 of government expenditure savings) is much higher than previously estimated. European governments, willingly or unwillingly, are repeating the mistakes of Japan, and the price they will pay for that will be astronomical.

#4: The crisis abates                 

On that upbeat note I will move swiftly to the fourth possible path – a relatively benign outcome where the crisis gradually abates, as it appears to be doing at the moment, and interest rates, as a result, normalise little by little. As a result, policy rates move up (very gradually) whereas long rates come down in the European periphery and go up elsewhere. Although this would be the best of all outcomes, it is unfortunately a scenario which is not very likely to unfold.

As recognised even by the IMF (!), the difference between the rate of interest paid on public debt and the growth rate of the economy (both measured in real terms) is “an important driver of debt dynamics, underscoring the importance of maintaining or restoring market confidence and growth”.4

Translation: If you are loaded with debt, and real interest rates exceed the real growth rate of the economy for any meaningful period of time, you are toast! On that account, the European periphery is well and truly toast (chart 5). So, even if path number 4 is probably the most desirable outcome, it is not the most likely.

#5: Eurozone fatigue                 

Finally, path number 5 – also known as the eurozone fatigue syndrome. Little by little, investors turn their attention to other matters, even if the problems in the European periphery remain. Investors simply can’t stand to hear and read more about Europe’s problems. This is to some degree already happening. It is just too early to say whether it is a temporary or permanent shift in sentiment.

Chart 5:  Interest Rate – Growth Differential, 2012 (%)

Source:   IMF Fiscal Monitor, October 2012.

If it turns out to be of a more permanent character, cyclical factors will return to the forefront of investors’ minds and central banks will become more likely to raise policy rates after five years of extremely accommodating monetary policy. If that were to happen, investors in bonds would be well advised to remember two lessons from the past:

  • When interest rates are low (as in 1954), even a modest increase in rates can have a dramatic effect on the performance of bonds. In the 1950s bear market, the yield on Aaa-rated bonds rose by 1.8% over a 69-month period. The value of those bonds was down 15% at the bottom of the cycle (chart 6).


  • When bond prices ultimately reverse, it may take a very long time to recover your losses. In the big bond bear market of the late 1970s and early 1980s it took five years. In the 1950s bear market it took almost nine years.

Our friends at Welton Investment Corporation have written a small masterpiece on this topic which you can find here.

Chart 6: The Biggest Drawdowns on Aaa-rated Bonds, 1919-2012

Source:     “When Bonds Fall: How Risky Are Bonds if Interest Rates Rise?”, Welton Investment Corporation, October 2012.


Now, let’s see if I can put it all together. First a quick summary of the facts:

  • Government de-leveraging has not yet started in earnest.
  • Austerity destroys more growth than most are prepared to admit.
  • The economic impact of current policy measures will thus be enormously negative.
  • Only a dramatic shift in economic policy can prevent a repeat of Japan’s misery.

That’s approximately where we stand today. The countries on the extreme left hand side of chart 5 (Greece, Portugal, Italy, Slovenia and Spain in that order) may never be able to pay back their debts unless (a) there is a fundamental change in economic policy, (b) they undergo a massive debt restructuring, or (c) Germany and the other creditor nations in the eurozone continue to cough up billions (possibly trillions) of euros. For everyone’s sake, let’s hope that the inmates who run the asylum aim for option (a).

I am not too hopeful, though. The optimist inside me believes there is a decent probability of path # 5 – eurozone fatigue – coming to fruition. I would assign a 30% probability to that. The pessimist (realist?) fears that path # 3 – the debt crisis spreads – will prevail. I will assign a 40% probability to that outcome. The other three scenarios I all consider less likely and will only assign a 10% probability to each.

This implies that a widening of the debt crisis outside of the European periphery is our base case. Now, how markets would react to that depends on:

  • whether the problems are still contained inside the eurozone (should Japan get dragged in to the crisis, all bets are off); and
  • the economic significance of the new crisis countries; adding France to the list of crisis countries would be a great deal more serious than if it were Slovenia.

With all those caveats in mind, the implication is that, in such an environment, policy rates would stay low for much longer than anybody currently expects; however, bond yields would quite likely begin to creep higher outside of the periphery, not as a result of inflation fears but because of the change in perceived credit risk.

More generally, it would also mean that risk assets would probably continue to deliver modest returns at best. We could possibly be stuck in a low return environment for years to come. I had the pleasure of meeting Howard Marks (of Oaktree Capital) recently for the very first time. Speaking at a conference in Germany, he quoted the great, and sadly missed, Peter Bernstein who once uttered the famous words:

“The market is not an accommodating machine. It won’t provide high returns just because you need them.”

Never have those words made more sense.

Niels C. Jensen

6 November 2012

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1    “The Superior Person’s Book of Words”, Peter Bowler

2    “A Simple World”, GK Research, 2 November 2012

3    Primary dealers serve as trading counterparties of the Fed when QE is implemented. See the list of U.S. primary dealers here.

4    Source: IMF Fiscal Monitor, October 2012, pp 11-12.


(c) Absolute Return Partners

What’s the Use of Economics?

By Alan Kirman, Professor Emeritus at the Universite Paul Cezanne in Aix-en Provence (originally published on VOX)

The economic crisis has thrown the inadequacies of macroeconomics into stark relief. This column argues that the narrow conception of the macroeconomy as a system in equilibrium is problematic. Economists should abandon entrenched theories and understand the macroeconomy as self-organising. It offers detailed suggestions on what alternative ideas economists can teach their future students that better reflect empirical evidence.

The simple question that was raised during a recent conference organised by Diane Coyle at the Bank of England was to what extent has – or should – the teaching of economics be modified in the light of the current economic crisis? The simple answer is that the economics profession is unlikely to change. Why would economists be willing to give up much of their human capital, painstakingly nurtured for over two centuries? For macroeconomists in particular, the reaction has been to suggest that modifications of existing models to take account of ‘frictions’ or ‘imperfections’ will be enough to account for the current evolution of the world economy. The idea is that once students have understood the basics, they can be introduced to these modifications.

A turning point in economics

However, other economists such as myself feel that we have finally reached the turning point in economics where we have to radically change the way we conceive of and model the economy. The crisis is an opportune occasion to carefully investigate new approaches. Paul Seabright hit the nail on the head; economists tend to inaccurately portray their work as a steady and relentless improvement of their models whereas, actually, economists tend to chase an empirical reality that is changing just as fast as their modelling. I would go further; rather than making steady progress towards explaining economic phenomena professional economists have been locked into a narrow vision of the economy. We constantly make more and more sophisticated models within that vision until, as Bob Solow put it, “the uninitiated peasant is left wondering what planet he or she is on” (Solow 2006).

In this column, I will briefly outline some of the problems the discipline of economics faces; problems that have been shown up in stark relief during the current crisis. Then I will come back to what we should try to teach students of economics.

Entrenched views on theory and reality

The typical attitude of economists is epitomised by Mario Draghi, President of the European Central Bank. Regarding the Eurozone crisis, he said:

“The first thing that came to mind was something that people said many years ago and then stopped saying it: The euro is like a bumblebee. This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years. And now – and I think people ask ‘how come?’ – probably there was something in the atmosphere, in the air, that made the bumblebee fly. Now something must have changed in the air, and we know what after the financial crisis. The bumblebee would have to graduate to a real bee. And that’s what it’s doing” (Draghi 2012)

What Draghi is saying is that, according to our economic models, the Eurozone should not have flown. Entomologists (those who study insects) of old with more simple models came to the conclusion that bumble bees should not be able to fly. Their reaction was to later rethink their models in light of irrefutable evidence. Yet, the economist’s instinct is to attempt to modify reality in order to fit a model that has been built on longstanding theory. Unfortunately, that very theory is itself based on shaky foundations.

Economic theory can mislead

Every student in economics is faced with the model of the isolated optimising individual who makes his choices within the constraints imposed by the market. Somehow, the axioms of rationality imposed on this individual are not very convincing, particularly to first time students. But the student is told that the aim of the exercise is to show that there is an equilibrium, there can be prices that will clear all markets simultaneously. And, furthermore, the student is taught that such an equilibrium has desirable welfare properties. Importantly, the student is told that since the 1970s it has been known that whilst such a system of equilibrium prices may exist, we cannot show that the economy would ever reach an equilibrium nor that such an equilibrium is unique.

The student then moves on to macroeconomics and is told that the aggregate economy or market behaves just like the average individual she has just studied. She is not told that these general models in fact poorly reflect reality. For the macroeconomist, this is a boon since he can now analyse the aggregate allocations in an economy as though they were the result of the rational choices made by one individual. The student may find this even more difficult to swallow when she is aware that peoples’ preferences, choices and forecasts are often influenced by those of the other participants in the economy. Students take a long time to accept the idea that the economy’s choices can be assimilated to those of one individual.

A troubling choice for macroeconomists

Macroeconomists are faced with a stark choice: either move away from the idea that we can pursue our macroeconomic analysis whilst only making assumptions about isolated individuals, ignoring interaction; or avoid all the fundamental problems by assuming that the economy is always in equilibrium, forgetting about how it ever got there.

Exogenous shocks? Or a self-organising system?

Macroeconomists therefore worry about something that seems, to the uninformed outsider, paradoxical. How does the economy experience fluctuations or cycles whilst remaining in equilibrium? The basic macroeconomic idea is, of course, that the economy is in a steady state and that it is hit from time to time by exogenous shocks. Yet, this is entirely at variance with the idea that economists may be dealing with a system which self organises, experiencing sudden and large changes from time to time.

There are two reasons as to why the latter explanation is better than the former. First, it is very difficult to find significant events that we can point to in order to explain major turning points in the evolution of economies. Second, the idea that the economy is sailing on an equilibrium path but is from time to time buffeted by unexpected storms just does not pass what Bob Solow has called the ‘smell test’. To quote Willem Buiter (2009),

“Those of us who worry about endogenous uncertainty arising from the interactions of boundedly rational market participants cannot but scratch our heads at the insistence of the mainline models that all uncertainty is exogenous and additive”

Some teaching suggestions

New thinking is imperative:

  • We should spend more time insisting on the importance of coordination as the main problem of modern economies rather than efficiency. Our insistence on the latter has diverted attention from the former.
  • We should cease to insist on the idea that the aggregation of the choices and actions of individuals who directly interact with each other can be captured by the idea of the aggregate acting as only one of these many individuals. The gap between micro- and macrobehaviour is worrying.
  • We should recognise that some of the characteristics of aggregates are caused by aggregation itself. The continuous reaction of the aggregate may be the result of individuals making simple, binary discontinuous choices. For many phenomena, it is much more realistic to think of individuals as having thresholds – which cause them to react – rather than reacting in a smooth, gradual fashion to changes in their environment. Cournot had this idea, it is a pity that we have lost sight of it. Indeed, the aggregate itself may also have thresholds which cause it to react. When enough individuals make a particular choice, the whole of society may then move. When the number of individuals is smaller, there is no such movement. One has only to think of the results of voting.
  • All students should be obliged to collect their own data about some economic phenomenon at least once in their career. They will then get a feeling for the importance of institutions and of the interaction between agents and its consequences. Perhaps, best of all, this will restore their enthusiasm for economics!

Some use for traditional theory

Does this mean that we should cease to teach ‘standard’ economic theory to our students? Surely not. If we did so, these students would not be able to follow the current economic debates. As Max Planck has said, “Physics is not about discovering the natural laws that govern the universe, it is what physicists do”. For the moment, standard economics is what economists do. But we owe it to our students to point out difficulties with the structure and assumptions of our theory. Although we are still far from a paradigm shift, in the longer run the paradigm will inevitably change. We would all do well to remember that current economic thought will one day be taught as history of economic thought.


Buiter, W (2009), “The unfortunate uselessness of most ‘state of the art’ academic monetary economics”, Financial Times online, 3 March.
Coyle, D (2012) “What’s the use of economics? Introduction to the Vox debate”,, 19 September.
Davies, H (2012), “Economics in Denial”,, 22 August.
Solow, R (2006), “Reflections on the Survey” in Colander, D., The Making of an Economist. Princeton, Princeton University Press.