Archive for Special Reports

10 Questions (and Answers) for 2013

I’m doing a pre-emptive Q&A this week covering a  macro view of 2013.  I generally don’t believe in forecasting a full year out because I think it’s impossible, but that doesn’t mean we can’t provide some general guide posts for the year given what we currently know.  I usually update these views on a quarterly basis (more frequently through the research with specific market views) so this is probably more like a Q1 outlook with some vague 2013 commentary.  And unfortunately, because the fiscal cliff remains unresolved a lot of this is just pure speculation….But I hope this helps frame the big picture for you.

1) What Will Happen With US Fiscal Policy?

With the fiscal cliff still entirely unresolved this one remains a bit hard to decipher.  A worst case scenario of $500B+ in cuts to the 2013 budget would drive us down from 2012’s $1.1T budget to something in the $600B range.  With a private sector that is still de-leveraging and unable to run with the baton since the damage of the credit crisis has been inflicted this would obviously have very damaging effects on the economy.  Recession is a near certainty in a worst case scenario.

The more likely scenario is moderate cuts and another year of economic muddle through as the budget deficit remains large enough to offset a healing private sector.

Downside risk: The obvious risk is Washington.  A poor outcome on the fiscal cliff means an already fragile economy will be driven into recession.  I am substantially more concerned about recession in 2013 than I was in 2012 as the risk of austerity is higher.

2)  What Will Happen with US Monetary Policy?

This one looks like a no-brainer.  The Fed has been pretty clear that they’ll remain accommodative through 2015.  The recent change in communication and timing made it clear that they’ll be on hold until the unemployment rate drops below 6.5%.  Even in a best case scenario the unemployment rate likely won’t hit 6.5% until the middle of 2014 so it looks like we’re in accommodation mode for the duration of 2014.

Downside risk:  Ben Bernanke is likely to step down in 2014.  Could he become less accommodative later in the year in order to create flexibility for a smoother transition?  Or could policy take an unexpected turn due to the uncertainty that is likely to develop in the market surrounding this event?

3)  Is the US Economy Headed into a Recession?

I’ve been pretty vocal over the last 18 months since the ECRI came out with their recession call.  I said the US economy would not enter a new recession in late 2011 or 2012.  The thinking was relatively simple.  Because the US economy remained in a balance sheet recession you had to throw all the past historical data out.  None of the models applied to what we are going through.  What did apply was understanding how the US economy was de-leveraging and that meant the private sector was too weak to sustain growth on its own.  That meant we needed the public sector to pick up the slack.  You’ve probably seen this chart (or some version of it) a million times here:

What happened to the US economy was an unprecedented collapse in private investment.  Normally, the private sector alone can bring us out of a recession.  But this was no ordinary recession.  Private investment cratered over 20%.  This was beyond unusual.  It meant the private sector was flat on its back.   And more importantly it meant that the huge public deficit was supporting incomes, driving revenues, and generating an economic “flow” where there wasn’t one.

It’s kind of like the office building called the US economy was burning down and the indoor sprinkler system stopped working.  A balance sheet recession isn’t merely a contained one office fire.  It has the potential to wreck the building.  So, what was needed was an outside flow.  That arrived in the form of government spending.  It not only put the fire out, but saved the building from collapsing.

Anyhow, it’s hard to tell whether there will be a recession in 2013 due to the fiscal cliff circus, but if we get a relatively sane response then the budget deficit should remain large enough to support the private recovery in 2013.  On the other hand, in a negative cliff outcome the US economy almost certainly suffers the European fate of austerity in a BSR and enters recession.  I am going to make the insane call of assuming politicians will do the sane thing in the next few weeks and avoid a major budget catastrophe in 2013.  Therefore, I still don’t see the recession in the USA this year, but the odds are substantially higher than they were in 2012.

Downside risk:  It’s all about the cliff.

4)  Is Global Growth Going to Slow?

Global growth appears to be stabilizing.  The USA has maintained a muddle through environment, Europe has been mired in recession and Asia has stumbled a bit in late 2012.  But that third leg of the stool (Asia) appears to be turning a corner.  This has been apparent in global PMI data where the GDP weighted PMI is turning positive for the first time since early 2012.  I think global GDP should stabilize further in 2012 largely on the back of a stabilizing Chinese economy.

Downside risk:  The Chinese government fails to act in front of a still very fragile economic environment.

5)  Is the Euro Crisis Over?

The Euro crisis never ended.  As I’ve explained before, this remains a currency crisis and not a banking crisis.  The problem in Europe is that the Euro remains unworkable.  The single currency system has locked its users into a fixed exchange rate regime without a fiscal rebalancing mechanisms.  In other words, unlike the USA (which is almost perfectly analogous to Europe’s union) there is no central treasury to rebalance any imbalances.  Most people aren’t aware of the fact that the USA is actually a huge fiscal transfer union.  The wealthy states pay more into a system that redistributes funds to weaker states.  This helps eliminate the solvency concerns and trade imbalances that naturally develop in any fixed exchange rate system.

Europe has no such arrangement so the only rebalancing mechanism is through painful austerity and time.   The result is depression in many regions. Unfortunately, there hasn’t been any permanent fix to this problem.  Instead, the ECB has implemented a series of measures that help reduce the solvency risk at the national level which brings private bond buyers back to the market, but this is far from a permanent fix to the underlying economic problems in the region.  The Euro crisis remains one of the primary risks to the global economy.

Downside risk:  The big risk is civil unrest which leads to potential defections and defaults.  The citizens of Europe are unlikely to put up with depressionary economics forever.

6)  Where is US Employment Headed?

Last year I said we were making “baby steps” in the right direction on the employment front.  Understanding the balance sheet recession has been all about understanding the growth of private credit.  As the lifeblood of our monetary system private credit tends to correlate with the unemployment rate and rate of hiring.  The one positive trend we’ve seen on the employment front is the beginning of gains in private credit accumulation.  As you can see in the chart below, private credit (inverted) is beginning to turn the corner.  The process is slow and remains incredibly fragile, but it’s moving in the right direction.  I don’t think it’s unreasonable to assume that the unemployment rate will drop below 7% this year for the first time since the crisis flared up.

Downside risk:  Again, it’s all about the cliff and austerity.  Austerity would hurt private balance sheets and likely cause a freeze in credit accumulation and hiring.

7)  Will High Inflation Finally Arrive in 2013?

In 2012 I expected disinflation leading to a level where the Fed would feel comfortable intervening with QE3 around the middle of the year.  I’ve been lucky predicting inflation in recent years.  Looking forward, we’re likely to see many competing forces on the inflation front in 2013.  Oil prices are still very high, credit trends are improving, government spending remains high and yet hourly earnings are still near rock bottom.  Ultimately, I think the two primary drivers will be credit trends and hourly earnings.  Continuing weak demand for credit and virtually zero earnings power on the labor front will continue to suppress inflation.  Contrary to popular opinion, I am not a deflationist and haven’t been for many years.  So, I see positive inflation, but low inflation in 2013.

Downside risk: Or should I say “upside risk”?  It is definitely oil prices.  A repeat of something like 2008 cannot be ruled out.  Particularly with the volatility in the Middle East.

8)  Will hyperinflation finally come in 2013?

I’ve had a lot of fun over the years at the expense of the hyperinflationists.  But that was mostly in trying to create a teachable moment about the way our monetary system works (see here for more). As I’ve long predicted, hyperinflation is not a serious risk in the USA because hyperinflation is far more than a monetary phenomenon and none of the conditions that precede hyperinflationsts are present in the USA.  I would place the risk of hyperinflation in the USA in 2013 at approximately 0%.  I’d go negative if I could.

Downside risk:  None.  I honestly don’t think there is any risk of hyperinflation in 2013.

9)  Should You Buy a House in 2013?

5 years ago I was a big housing bear.  I wouldn’t say that I’ve done a 180 here, but I’ve definitely become much more constructive on housing in recent years (see here and here).  The keys in the housing market has been sizable declines in inventory, vast improvements in affordability, improving price to rent ratios and substantial price declines across the nation.  I still think we’re in the midst of a post-bubble “workout”.  Like most bubbles, it’s highly unusual for prices to bounce back quickly.  Instead, we’re likely to see a flat-lining in prices.

Despite the many calls for recovery this year, I still don’t see a big recovery in housing.  That said, I also don’t see great downside in prices.  We’ve already had a massive decline in real house prices so I think we’re most likely to see moderate gains at best in 2013.  If you’re looking to buy a home in 2013 and you’re looking to live in that house then I think the downside risk are fairly limited.

Downside risk:  I hate to be a broken record, but the risk here is in the fiscal cliff and the potential that incomes from government spending decline substantially which puts downside pressure on the economy.

10)  What Will Happen to Corporate Profits in 2013?

Last year I predicted that corporate profits were likely to come under pressure for the first time since 2009.  As Q3 operating earnings come in at just 1% I think that has become a reality.  There are a lot of moving parts here, but the likelihood of slow corporate profit growth is likely to continue into 2013.  Revenues are slowing into the low single digits, corporate profit margins are high and profits have soared on the back of the large budget deficit.  I think the risk to all of this is to the downside.  I am much more concerned about a profits recession in 2013 than an economic recession.

Downside risk:  Again, understanding the Kalecki equation shows us that corporate profits have benefited enormously from the large budget deficit.  If the fiscal cliff results in a substantial decline in the budget in 2013 we should expect a profits recession.


By Niels Jensen, Absolute Return Partners

“In the science of physics, we know that water freezes at 32 degrees. We can predict with immense accuracy exactly how far a rocket ship will travel filled with 500 gallons of fuel. There is preciseness because there are constants, which do not change and upon which equations can be constructed.” – Robert Wenzel, Editor of the Economic Policy Journal, speaking at the New York Fed

In the science of economics there are no such constants, yet investors often behave as if they operate in a world of logic and certainty. Because such assumptions are made, history is littered with investors who have failed miserably.

Before I go any further, allow me to take you back in history for a moment – more precisely to year 1,012. My Viking forefathers had already raped and pillaged their way through the British Isles for more than a century and King Knut was only six years away from bringing the Danish and English crowns together for the first, and last, time. Having been captured by the Danes the previous year in a raid on Canterbury, 1,012 was also the year that Ælfheah, the Archbishop of Canterbury, was brutally murdered by a Danish mob after he refused to be ransomed.

It was also in year 1,012 that little Johnny was born. He was a thrifty lad and, almost immediately, put £1 into his piggy bank. It didn’t take him long to realise that the piggy bank wouldn’t earn him any interest so he began to lend money to the farmers in his village, allowing them to harvest ever larger areas of farmland. All Johnny demanded was a modest rate of interest amounting to inflation + 3% which was not unreasonable. After all, he took risks that he should be paid for. It was a perfectly rational request.

Johnny was not only thrifty; as he grew into a young adult he taught his own children some business acumen, so, long after Johnny had perished as an old but wealthy man, his children and their children continued to earn a modest 3% over inflation, year in, year out. 40 generations later, Johnny’s great-great… grandson is now easily the wealthiest man on earth with a personal fortune of no less than £6.87 trillion. That’s the power of compounding.

Now, we all know that there is no single person on this planet worth anywhere near £7 trillion, so something is wrong with my maths. Apart from the evil called the tax man – the obvious mistake I make is not taking into account the value destruction which has decimated our wealth at regular intervals since the sun rose for the very first time – due to war, disease, bursting asset bubbles, or because some odd meteor from outer space chose to crash land in our backyard. The reasons are many but the end result the same.

The point I want to make here is that our brains are not calibrated to deal with the unexpected. Most of us believe we are good risk managers but in reality we are not. Most of us trust that risk can always be quantified and expressed through some fancy modelling whereas, often, it cannot. When I went to lunch on the 11th September, 2001, little did I know – or expect – that less than an hour later I would get a call from my assistant suggesting that it was probably best if I came back to my desk as quickly as I possibly could.

The world is not normal, yet universities continue to teach our young students the wisdom of Markowitz and Sharpe which brought us modern portfolio theory and, more specifically, the capital asset pricing model. Garbage In, Garbage Out, as they say. One of the fundamental assumptions behind modern portfolio theory is that asset returns are normally distributed random variables. I suggest you take a glance at chart 1 below. The bright (smooth) blue line depicts a perfect normal distribution. The darker (uneven) blue line represents actual equity market returns over the past couple of decades. Even the untrained eye can see that the return profile of US equities fairly closely matches that of a normal distribution with the exception of large negative returns. They have come about more frequently than one would or should expect.

Chart 1:  The Return Distribution of Equities is Non-Normal

Source: “Global Volatility Outlook 2012”, Barclays Capital.

Note: Histogram of 3-month overlapping returns of S&P500 since 1990.

You can’t model risk, yet armies of risk managers all over the world attempt to do so every day of the year. Value-at-Risk (VaR) is a prime example of such thinking. If a risk manager notifies the portfolio manager that his one day 1% VaR is $8 million, he basically tells the manager that there is a 1% probability of losing more than $8 million in one day’s trading. VaR assumes normally distributed returns. We already know that large negative returns occur more frequently than one might expect, so a use of the VaR model in isolation or relying on the absolute numbers only is likely to lead to the risk manager underestimating the frequency and magnitude of large losses. That is not the only problem, though.

We know from experience that periods of relative calm – and hence low volatility – often precede panic. VaR falls when volatility drops so, following a period of low volatility, the risk manager will often allow the portfolio manager to increase his risk taking, for example through increased use of leverage. In other words, the portfolio manager may walk straight into a financial storm with far too much risk on his books, if such storm has been preceded by a period of more benign market conditions.

Furthermore, VaR establishes the largest loss that the portfolio manager is likely to lose 99% of the time (assuming the risk manager uses 1% VaR) but it says nothing about what might happen in the remaining 1% of cases. Isn’t that at least as important and probably more so? After all, 1% still accounts for two, maybe three, trading days every year. VaR is a quasi useful tool in the right hands but a highly toxic one in the wrong hands.

The brilliant economist Hyman Minsky understood this only too well. Whilst lecturing at University of California, Berkeley, he developed the thesis that stability in itself is destabilising – an idea that led to his Financial Instability Hypothesis. Not surprisingly, Minsky’s ideas have attracted widespread attention more recently, following the worst financial crisis of three generations which came about after years of unprecedented prosperity.

Stability breeds instability for several reasons – key amongst them is our inclination to look in the rear mirror for clues about the future. Portfolio managers, risk managers and regulators all tend to do so when looking for clues as to where the system is vulnerable. U.S. residential mortgage loans offer a prime example of such behaviour (see chart 2).

Chart 2:  Charge-Off Rates for Residential Mortgage Loans and Business Loans

Source:, Federal Reserve Bank of St. Louis.

During the recession of 1990-91, charge-off rates (i.e. bad loans) on U.S. residential mortgage loans (the red line in chart 2) hardly changed. Broadly the same picture emerged during the 2001 recession. Business loans, on the other hand, demonstrated a classic cyclical pattern with a significant rise in charge-offs during both those recessions (the green line in chart 2). Based on this knowledge, going into the 2007-09 recession, consensus was that residential mortgages would do relatively well in a recession whereas business loans would experience a significant pick-up in charge-offs. As we all know now, this turned out to be the mistake of the century and one which I, to my great regret, made myself. Never fight the last war when managing risk! 

Whether we like it or not, we will continue to make mistakes. It is simply part of human nature. However, the effect mistakes have on financial markets are compounded when they are correlated. A “correlated” mistake is one in which investors share a common forecast that proves to be wrong. An “uncorrelated” mistake is one where investors’ forecasts are widely spread out symmetrically around the eventual outcome (the Truth). Our economic adviser Woody Brock makes the following observations on correlated versus uncorrelated mistakes:

 “The more correlated the forecasting mistakes of the individuals in a market are, then the greater the market correction (and hence volatility) will be in the market once the Truth is learned. When forecasts are uncorrelated and distributed symmetrically around the Truth, then once the Truth is learned, for every seller there will be a buyer and market price does not change. There is no volatility. In the case of a correlated structure, the reverse is the case: everyone becomes either a buyer or a seller in unison, resulting in sharp changes in price.”

Leaning on Kindleberger’s work, Woody Brock goes on to conclude:

“In applying this insight to help explain the case study of the Global Financial Crisis three years ago, I arrived at what I have termed the Fundamental Theorem of Risk: A Perfect Financial Storm will occur when (1) investors have bets based upon very similar forecasts, (2) their bet is a “big” one, for example, a bet on the price of their principal asset (their house), and (3) both investors and their banks are maximally leveraged. It can be demonstrated formally that these three conditions will generate a Perfect Storm of maximal volatility — and note how perfectly these three conditions were met in the US housing market collapse. The role of excess leverage is to nonlinearly amplify market distress.”

Woody Brock’s work is critical in terms of understanding why 2011 turned out so differently from 2008 and, more importantly, why the painful experience of 2008 is not likely to be repeated any time soon, at least not in Europe or the United States. In 2011, investors were (and still are) deeply divided as to the longer term consequences of the policy being pursued – witness the great deflation vs. inflation debate – so Woody’s first condition (investors having bets based upon very similar forecasts) was not met in 2011 and is still not met today unlike in 2008 where all three conditions were fulfilled in abundance.

Abuse of statistics is another source of poor risk management in our field. One such example is the widespread confusion between correlation and causation. Just because a statistician can prove a correlation between ice cream consumption in Angola and the number of single mums in Panama doesn’t mean that there is causation (i.e. one is a function of the other).

Neither are correlations stable over time as so amply demonstrated in chart 3 below. Those who based their risk management approach around 1999-2000 on the assumption that US Treasuries and US equities were positively correlated were in for a rude awakening. Today everyone takes for granted that the two are negatively correlated. For now they are but for how long?

Chart 3:  Rolling 5-Year Correlation of US LT Treasuries vs. S&P 500

Source: Richard Bernstein Advisors. Note: Total returns, Dec 1980 – Dec 2011.

My favourite case of data abuse is unquestionably Reinhart and Rogoff’s work on debt versus economic growth (see here). In their much quoted research paper they state the following:

“We have shown that public levels of debt/GDP that push the 90 percent threshold are associated with lower median and average growth; for emerging markets there are even stricter thresholds for external debt while growth thresholds for advanced economies remain an open question due to the fact only very recent data is available.”

These four rather innocuous sounding lines have since become gospel in many quarters. It is now widely accepted that 90% debt-to-GDP is the invisible line in the sand. Once crossed, you are doomed. Economic growth will tank and you will ultimately default on your obligations, or so many believe.

The reality is that Reinhart and Rogoff’s work is based on a relatively small sample of countries of such disparity in socioeconomic profiles that providing an average figure is almost meaningless. It is akin to suggesting that yesterday was a very pleasant day with an average temperature of about 20C when in fact it was -10C at night and +50C during the day – both highly unpleasant. However, and for the record, I don’t blame Reinhart and Rogoff who did caveat their findings; no, the blame lies firmly with all those who have taken those findings at face value and used them out of context.

Another example of poor risk management is the one-dimensional thinking so often exuded by investors. It manifests itself in a number of ways.  More recently it has become clear to me that investors are incapable of focusing on more than one crisis at any given point in time. 2011 became the year of the euro crisis; pretty much nothing else mattered. The inability to apply multi-dimensional thinking is also clear from how markets treat economic news. In the U.S., (un)employment data have stolen most of the headlines in recent months with less emphasis on other, and equally important, economic statistics. This could have significant implications for financial markets. Here is why.

I suspect that the U.S. economy is in the process of inheriting Europe’s long standing problem of high structural unemployment. If my fears are well founded, investors are likely to underestimate the strength of the U.S. recovery as they will mistakenly conclude that continued high unemployment is synonymous with persistent economic weakness. It may not necessarily be the case if the unemployment is structural in nature. Allow me to show you a chart supporting my suspicions (chart 4). The green line is a proxy for the output gap and used by the Fed. The red line is the Fed funds rate. Two observations immediately stand out: (1) The two correlate relatively well over time, and (2) The output gap has now all but evaporated since it peaked in late 2009. In plain English: the economy is stronger than suggested by the employment data and, more importantly, the Fed may be forced to raise rates as they are increasingly at risk of falling behind the curve. This may also explain why there is growing dissent inside the ranks of the Fed.

Chart 4:  Is the Federal Reserve Bank Behind the Curve? 

Source: UBS, Bloomberg

I could go on and on. I could mention (some) investors’ one-dimensional focus on the absolute level of P/E ratios when it makes little sense to assess P/E ratios without taking the level of interest rates into consideration. Following this logic, investors should pay more attention to the equity risk premium and less so to the absolute valuation of equities.

Or I could talk about the effect the ‘risk on – risk off’ mentality has had on the ability to diversify risk. In today’s environment asset classes fall into one of two categories – they are either risk assets or safe haven assets. Traditional diversification techniques have stopped working with significant implications for asset allocation and portfolio construction.

Perhaps I should also have allocated more time and energy to one of the classic traps of investing – investor overconfidence. Most investors have a remarkable and deeply fascinating ability to blame others for their mistakes whilst giving themselves credit for all the correct investment decisions. As my old boss used to say – Don’t confuse genius with bull market.

The list goes on and on. Instead I will finish this letter by looking into the future and give my response to the all important question: Where should investors look for the next big crisis? Many pundits are pointing to the bond market as an accident waiting to happen. Andy Xie says that the current policy “will lead to catastrophic bond market collapse”. Frank Veneroso says “bonds and bunds at these yields are a sheer madness”. Both men are widely respected and very astute observers of financial markets; however, if Woody Brock’s logic proves correct, betting on the bond market as a major accident waiting to happen may prove rather futile. My money is on Asia. Here is the logic.

We know from experience that an asset bubble that bursts is likely to create what are often referred to as echo bubbles. An echo bubble is a follow-on bubble from the initial asset bubble and is usually created when monetary and/or fiscal policy is relaxed in response to the bursting of the initial bubble. Some market observers have actually argued that the financial crisis of 2008 was in fact the bursting of an echo bubble created by the very lax monetary policy created in response to the bursting of the dot com bubble in 2001-02.

We also know the effect artificially low interest rates can have on a country. Think Spain or Ireland, both of which adopted artificially low interest rates when they first joined the eurozone; however, rates were low at the time to accommodate a rather weak German economy. The low rates did wonders for Ireland and Spain in the early years of the eurozone membership but it is now painfully clear that enormous excesses were created as a result.

Now switch your attention to Asia. Many Asian currencies are pegged to the U.S. dollar, either directly or indirectly. As a result, the central banks of those countries are forced to keep the policy rate at a level which may be entirely inappropriate for the rapidly growing Asian economies. Obviously, removing the dollar peg would address this dilemma, but that is a pie in the sky so long as the mercantilist approach that most Asian countries subscribe to prevails.

The Bank for International Settlements published a paper recently where it pointed out just how lax monetary policy is throughout Asia. With the exception of Japan, every single country in the BIS study appears to be behind the curve (see chart 5). This raises all kinds of issues for Asia longer term – increased use of leverage, inflationary pressures, asset price bubbles, etc. Does it sound familiar?

Chart 5:  Policy Rates and Those Implied by the Taylor Rule

Source: BIS Working Paper No 378

To me it looks and sounds like a potential re-run of Europe. When it looks like a fish and smells like a fish, it usually is a fish. The parallels are certainly there for everyone to see, although Asia’s crisis may take years to unfold. Investors in Spain and Ireland had six or seven years of exceptional returns before the tide turned and those who exited prematurely left an awful lot of money on the table. At this stage we are merely monitoring events, but the yellow flag has been raised.

Perhaps the best the Asian monetary authorities can hope for is that the Fed takes a very hard look at chart 4 above and concludes that perhaps the U.S. does need higher interest rates after all. Such swift action might still save Asia from a repeat of the European malaise.




* This post was written in 2011 before Mr. Roche founded Monetary Realism, which was formed due to several disagreements Mr. Roche and many other former MMT proponents had with the school of thought.  For more info on the difference in views please see here.  For more on MR’s views please see here.

The MMR conversation on savings and investment has now raged to over 600 comments.  It would be an understatement to say that the conversation has been illuminating.  To me, one of the more interesting facets of this discussion is the fact that we have MMTers, horizontalists (like Ramanan), MMRists and previously undecideds (like the mysterious JKH) all agreeing!  I think this speaks volumes about the merits of what MMR is building.  Our flexible, fact based and apolitical approach is proving agreeable to many and I hope we’ll continue to embrace even those who might disagree with much of what we say.

But the most illuminating point that came from the discussions was the point on S = I + (S-I), where S = Savings, I = Investment.  Now, for the layman, I will try to break this down as best I can so bear with me.  What we learn from the sectoral balances approach is that the government’s deficit is the non-government’s surplus.  If the government taxed all your assets at a rate of 100% then you’d have no dollar denominated assets.  That’s simple enough.   The sectoral balances is a powerful concept as it highlights the power of the government and helps explain why a sovereign currency issuer might run persistent budget deficits without running into a Greek problem (the USA for instance has pretty much always run deficits so the idea that deficits are inherently bad, is inherently wrong!).  But when we break this equation down we have to be very precise about what it means because improper explanation will lead one to put the cart before the horse.

One of the other powerful concepts I’ve been discussing in recent weeks is the MMR Law:

“We generate improving living standards through the efficient use of resources resulting in the optimization of time”

When we understand that our living standards primarily improve through the increasing efficiency of resource utilization (think of the many innovations that make our lives easier and essentially give us the ability to live fuller lives) we can then begin to see how it is the production process that helps to optimize time.  Time, as I have stated previously, is the universal form of wealth.

If we get back onto the S = I + (S-I) discussion then we can begin to connect the dots between everything here.  If you just glance at the sectoral balances equation you might conclude that the government drives wealth creation or you might be inclined to overstate the government’s role in the wealth creation process because you believe the private sector cannot save unless the government spends.  But this is a very delicate and crucial point.  Steve Waldman of the excellent blog interfluidity explains his thinking on this subject better than I can:

“It is perfectly possible to hold the international balance constant, have the government reduce debt, and have “people” save more. “People’s” financial savings consists of claims on firms and claims on government. If I perform some work for a firm that (however infinitesimally) increases the firm’s real economic value, and I accept as payment a share of that firm’s stock, I have performed the economic act of saving, and increased the net saving of “people” — of the household sector. Net private sector financial assets have not increased: my “savings” is the firms’ obligation, the household sector’s surplus is offset by the business sector’s deficit. But much of what we call saving is exchanging real resources for claims on the private business sector. And as long as the private business sector doesn’t entirely squander those real resources, that act contributes to macroeconomic S. If the private business sector does squander the resources, then while I still perceive my contribution as “saving”, the value of macroeconomic S = I does not increase, and my claim amounts to a transfer from other shareholders of the firm.”

You can think of this process as the private sector creating their own claims on wealth.  Yes, they can’t create net new financial assets, but for real world money users that’s a secondary concern.  The truth is, the state doesn’t have a coercive monopoly on money (the banks wield a HUGE amount of power) and the private sector can create its own financial assets (even though it can’t create net new financial assets).  But the kicker here is that once you understand the implications of the MMR Law you can see that S (Savings) is not truly driven just by government spending.  Rather, it is driven by I (Investment).   The always brilliant JKH has elaborated on this point thoroughly in the aforementioned discussion and has even started calling himself an MMRist (he can have the seat at the head of the MMR table any day, maybe he’s already sitting there!?!).  When you understand this, you can see that, as JKH says, “I is the backbone of S”.  In this regard it is best to think of government as being an accomodating force in the wealth creation process.

Perhaps most importantly, through this understanding we can see that capitalism makes socialism acceptable.  It is the production process that sits atop the hierarchy in our increasing trajectory of living standards.  It is the glue that binds everything.  It is the “backbone” not only of S, but I would argue, the entire monetary system.  Without the capital formation process,  the resulting production and the increase in living standards, we have nothing.  In this regard, capitalism makes socialism acceptable.  But there’s a balance between the two.  I just think it’s important to remember where each sits in terms of its importance to the future of our society and the trajectory at which we want our living standards to increase.


Time to put on my myth busting cap again.  This time, it looks like the USA is turning into Rome.  But probably not.  This is a comparison we almost always hear from hyperinflationists, those making ridiculous claims about the USA being bankrupt or those who are excessively worried about the influence of the government in the USA.  And maybe some of this is justified to a certain degree.  After all, it was largely government ineptitude that led to the decline of the Roman Empire.

Before any discussion about the Roman Empire begins, we should put things in perspective.  The rise and fall of Rome was a spectacular historical progression.  Although the fall of Rome is often described as some sort of event, the truth is that the rise and fall of Rome occurred over the course of 1,000 years with the final 200  years broadly being seen as the period of decline.   The USA has only existed for 235 years and has only been a superpower for about 100 of those years.  This doesn’t mean we have 765 years left to party, but some perspective is appropriate.  The tendency to view the fall of Rome as an event and not a gradual progression is highly misleading.

There are, in my opinion, three major differences between the Roman Empire and the USA.  They are:

    • The USA is not colonizing the world.
    • The USA is a very stable political environment.
    • The USA’s economic dominance continues.

Manifest Destiny is long gone….

The first point is one of the most important.   Any empire that overextends itself is bound to run into any multitude of problems trying to maintain stability outside of their direct sphere of influence.  At their peak, the Romans had conquered all of Eastern Europe, much of Western Europe, a large portion of northern Africa and much of the Middle East.  This was no small feat back in the days before cars, phones and internet.  Coordinating such a vast empire must have been a logistical nightmare.   And that’s exactly what it proved to be.  Not unlike the British Empire, this proved an impossible task as cultures clashed, coordination become increasingly difficult and authority from Rome diminished on the fringes.

Some people claim that the USA’s large military and policing of the world are somehow comparable to this.  But the reality is that we haven’t colonized any part of the world since 1959 when Hawaii became the 50th state.  It’s true that the USA went through a period of “manifest destiny” in which we essentially established what is now know as America, but those days are long gone.  We’re not in the business of colonizing the world or ruling foreign lands.  Yes, we are probably overextended on the military front and I am not sure why we often feel the need to police the world, but this is dramatically different than what the Roman Empire did through directly conquering and establishing their own leadership in other parts of the world and then attempting to maintain direct control over those regions.

Political Stability

The leading cause of the decline in the Roman Empire was political instability.  The Roman Empire was actually only one period of Roman prosperity.  Rome was many different styles of government over time with the Monarchy and then the Republic leading to its great rise and the Empire leading to its great decline.  The Empire led to considerable division within the Empire itself with the leadership, at times, being distributed across many different Emperors.  There was no real unification, but rather separate rulers as time went on.   The Roman Empire was generally fragmented between East and West and this lack of unification led to instability as time went on.

The United States is in no way comparable to the Empire of disunity or rule by Emperors.  We are and have always been a Constitutional Republic.  This form of government has proven remarkably stable with time.  And while we might see increasing disagreement among the various political parties within the USA, the foundation of our Republic is strong and stable.  There is no first or second triumvirate, no Brutus stabbing Caesar in the back, no overthrow of one government for another….There is only a stable progression of leadership chosen by the people and for the people.

Economic Prowess

I know it’s not popular to cite the continuing economic dominance of the USA, but the reality of the matter is that the USA is still the dominant economic power throughout the world.  Despite China’s incredible growth, the USA is still the largest economy in the world.  Our GDP per capita is almost 6 times China’s.  Nominal GDP is 23% of ALL world output.  If you combined ALL of the BRIC nations you’d still have an economy smaller than the USA’s.  We export more goods and services in the course of a year than the entire nominal GDP of Russia.

Now, clearly, the U.S. economy is in stall speed currently.  I am not trying to downplay the obvious rut the economy is in.  But let’s not be overly dramatic here.  The USA is still comprised of incredibly innovative and productive corporations and a people who seek the very best living standards in the world.  And while we might be a bit off track currently, I don’t see the trend in innovation and output collapsing any time soon.  I know it’s not popular to be optimistic about the future of this country, but let’s maintain a little perspective here.  The obvious direction from being #1 is becoming #2, but that doesn’t mean the American society is going to be overrun by vandals overnight to the point where it becomes a mere shadow of what it once was.

In short, the USA might be on decline (though I don’t really think so).   But one thing we’re not is the Roman Empire.  The comparisons are apples and oranges.



By Niels Jensen, Absolute Return Partners

What have Bill Gross, John Paulson, Anthony Bolton and Bill Miller all got in common? They are all ‘rock star’ fund managers who have fallen on hard times more recently. Life in the fund management industry is not what it used to be like. Life is tough even for the supremely skilled. Markets are changing, fund managers are struggling to adapt and clients are growing restless as a result.

If I told you that the composition of an average UK equity fund changes by 90% a year, would that startle you? How would you feel if I added that the 20 funds with the highest turnover returned just 4.7% to investors in the 3 years to the end of March 2011 whereas the 20 funds with the lowest turnover returned 16.8% over the same period?[1]

From the same source: Out of 1,230 funds across 12 different strategies, only 35 fund managers produced a performance consistent enough to earn their fund a place in the top quartile in each of the last three years (upper half of chart 1). In a universe of 1,230 funds, over a three year period and completely disregarding skill, the expected number of funds consistently ranked in the top quartile is 1,230*0.253=19.22.

In other words, more than half the 35 managers were there not because of skill but because, statistically, someone was always likely to ‘over-achieve’. This leaves about 15 fund managers out of a universe of 1,230 – ca. 1% – who could with some right claim that they have consistently been in the top quartile.

Chart 1:   The TRMC Consistency Ratio (through September 2011)

Source: Thames River Multi Capital Quarterly Survey

The problem is we don’t know who they are. All we know is that none of them are managing Asian equities, North American equities or Global fixed income funds as those three strategies didn’t produce a single top quartile performer between them. And when you look at the second, and slightly less demanding, part of the study – those who have been in the top half in each of the past 3 years – the picture is broadly the same (lower half of chart 1). 177 fund managers achieved the required consistency but 154 of the 177 are likely to have done so because of luck, not skill.

I have never come across a fund manager who openly admits that his (or her) outperformance is down to luck. On the other hand, I often come across fund managers who suggest their underperformance is down to bad luck. I suppose no manager ever skilfully underperforms, but to put it down to bad luck is an insult when we all know that human error is the most common cause of underperformance.

If a fund manager’s outperformance is based on skill rather than luck, wouldn’t one expect the majority of the outperformance to come from those stocks with the highest weights in the portfolio? This seems a reasonable assumption given that one would expect any rational fund manager to allocate the most capital to his/her highest conviction ideas.

However, in a study conducted by UK consulting firm Inalytics (see here), 39 of 42 Australian funds managers who outperformed their benchmark owed their outperformance to the ‘underweights’ in the portfolios – suggesting that human error is not only the source of underperformance but perhaps also of some of the outperformance.

Bestinvest produces an annual survey called Spot the Dog (see here for the latest survey) which has gained considerable attention in the UK fund management industry, although it is not a league table you will be proud to be mentioned in. According to the 2011 survey published back in August, over £23 billion is currently managed in so-called dog funds[2], an increase of no less than 74% since the previous report.

You don’t become a dog just because you have a bad quarter or two. The members of that exclusive club have a history of serial underperformance, yet they will generate in the region of £350 million of fees to their firms this year despite the obvious value destruction.

And the story gets worse – much worse in fact. According to an unpublished report conducted by IBM, our industry destroys $1,300 billion of value annually – a staggering 2% of global GDP (see here for details). This includes about $300 billion in fees on actively managed long-only funds which fail to outperform their benchmarks, $250 billion spent on wealth management fees for services which do not meet their benchmarks and $50 billion in fees on hedge funds which underperform. Do I need to say any more?

Why are fund managers finding it harder than ever to outperform and what are the long term implications of those miserable performance statistics? Let’s deal with the ‘why’ first. There is no question that managing money – in particular equity mandates – has been a delicate affair over the past decade.

Through the 1980s and 1990s global equity markets benefitted from a strong undercurrent of bullishness. As a result, fund managers went into the bear market of 2000-01 on a wave of optimism (who doesn’t recall the repeated calls in the late 1990s of a new investment paradigm?) epitomised by the record high P/E levels in 1998-1999 just before it all went pear shaped in 2000.

Since then investors have been punished for their optimism. As you can see from chart 2, those who bought UK equities in 1998, 1999 and 2000 and held on to them for 10 years have suffered the indignity of negative inflation-adjusted returns.

Chart 2:         The Link between Long-Term Returns and Starting Point P/E Ratios

Source:                    Blackrock, Oriel Securities.

Based on FTSE All Share Index as at 7 September, 2011. 2012 P/E = 8.9.

I believe much of the underperformance of recent years is a bi-product of the excessive optimism of the late 1990s. An entire generation of investors grew up believing equities would always go up in the long run. Since 2000 the investment environment has changed for the worse but the faith in equities has only gradually been undermined, causing fund managers to only slowly adapting to a more challenging environment.

Another factor making life difficult for active managers in more recent times is the rising dominance of the ‘risk on’ versus ‘risk off’ mentality. Not that it represents a new paradigm. Investors have always been either pro risk (risk on) or against risk (risk off). What is new is how those cycles appear to become more and more compressed and how investors increasingly demonstrate herd-like behaviour (i.e. most of us are either risk on or risk off at the same time).

It is not for me to speculate on why that is but the implications are there for everyone to see. As risk on switches to risk off, virtually all share classes sell off simultaneously, rendering simple portfolio techniques such as diversification largely useless. Until active fund managers embrace the new world and adjust their portfolio management techniques accordingly, they will likely continue to struggle.

Consulting firm FundQuest has analysed the performance of 32,730 US domiciled non-index mutual funds over a 30 year period (see chart 3). Managers were judged to have generated alpha if they beat their benchmark by more than 50 basis points.

Chart 3:         Correlations Up, Alpha Down % of Fund Managers Generating Alpha

Source: FundQuest, Funds Europe Magazine

Several conclusions stare the reader in the face:

  1. Giving money to active bond managers is (statistically) a losing proposition in any environment. When well over 50% underperform their benchmarks even at the best of times, it is hard to see the justification for using active managers in this asset class.
  2. Managers in charge of equity and commodity funds can only justify their existence in more benign market environments. When the going gets tough (risk off), less than half the managers deliver alpha.
  3. Alternative managers have nothing to be proud of. With only about half the managers generating alpha regardless of environment, you might wonder whether you should resort to the art of throwing darts.
  4. Multi asset class managers struggle badly (only 15% outperform) when correlations rise – not really surprising considering high correlations undermine the very idea of the multi asset class strategy (i.e. diversification across asset classes) but worth bearing in mind if the ‘risk on/risk off’ environment which has so dominated the investment landscape in recent years continues for a prolonged period of time.

So far my focus has been on actively managed long-only funds but that doesn’t imply that hedge funds are covering themselves in glory – far from it. Hedge funds have enjoyed tremendous growth in recent years, spurred on by what looks to the untrained eye as vastly superior returns when compared to long-only funds. In a research paper published back in January (see here) this perception was challenged.

Using data from 1980 to 2008, the authors calculated the compound annual return for the average hedge fund to be 13.8%, easily outperforming more traditional asset classes over the period in question. This number makes hedge fund managers look like superstars when compared to traditional fund managers and is used by the hedge fund industry as one of the key reasons why everyone should invest in hedge funds.

Now to the naked reality. The best performance in the hedge fund industry came in the early years when assets under management were much smaller. The authors adjusted for this by calculating dollar-weighted returns instead; i.e. more recent returns when assets under management have been much bigger carry a higher weight than more distant returns when assets under management were negligible. The dollar-weighted number is thus a much better proxy for actual profits earned by investors in hedge funds. For the whole period 1980-2008 that number is 6.1% as opposed to the 13.8% headline number. Hardly blowing your socks off!

Now, if the hedge fund universe is difficult to navigate, can funds of hedge funds add any value? Regrettably the answer seems to be a resounding ‘NO’. In the paper referred to above the buy-and-hold return on funds of hedge funds for the entire 1980-2008 period was 11.0% per annum whereas the dollar-weighted return was a much more modest 4.1% per annum.

In another study on the performance of funds of hedge funds (see here), the authors conclude that, during the period 1994-2009, only 21% of all funds of hedge funds generated pre-fee alpha and, once the extra layer of fees were taken into consideration, only 5-6% of all funds of hedge funds outperformed the hedge fund benchmark.

These results are obviously disappointing and explain why funds of hedge funds are struggling to keep up with the growth of the hedge fund industry. In 2007 funds of hedge funds accounted for about 43% of underlying hedge fund assets. Three years later, their share had dropped to 33%, suggesting that more and more hedge fund investors go directly rather than through funds of funds (see here for details).

As a footnote, and in the spirit of full disclosure, Absolute Return Partners’ main line of business used to be funds of hedge funds and it is no secret that our funds of hedge funds have struggled and continue to suffer the consequences of decisions made back in 2005-07 when we all thought we could walk on water.

So, if the performance of the average long-only manager stinks, the typical hedge fund does not fare much better and the run of the mill fund of funds add little or no value, what should investors do? Well, to begin with we should clean up the way investment products are sold and that is precisely what the UK regulator intends to do.

If the Financial Services Authority has it its way, from January 2013, the so-called Retail Distribution Review (RDR) will outlaw kick-backs from UK fund managers to IFAs. RDR will make life miserable for the dog funds – those that serially underperform but continue to survive because they pay handsome fees to introducers who are prepared to disregard the dismal performance. Instead, IFAs will have to charge their clients an advisory fee.

This is a step in the right direction for an industry which has undermined its own credibility for years by ‘bribing’ IFAs to sell poorly performing funds; however, the technocrats in Brussels (as if they didn’t have bigger and better things to worry about at the moment) are not entirely happy with the British initiative and have tried to throw a spanner in the works. We can only wait and see what the next twelve months bring.

In the meantime, ETFs and other index trackers are seen by many as the solution to poor performance, but ETFs are not without their share of problems. Hargreaves Lansdown, a leading UK financial services provider, states on its website that it offers access to more than 2,000 funds at no initial charge. On the other hand, as far as I have been able to establish, it doesn’t state anywhere that it won’t include a fund unless it receives a significant kick-back from the fund manager.

With ETFs becoming more and more popular amongst investors, Hargreaves Lansdown has seen the writing on the wall and has responded with an extra charge for holding ETFs and other index trackers on behalf of its clients, potentially undermining the ability of small investors to track indices (see here).

More worryingly, the problems do not end there (and I am no longer referring to Hargreaves Lansdown). Many index trackers are sold without full disclosure – such as commodity index trackers which are subject to the cost of carry and index trackers which are exposed to significant counterparty risk because the underlying collateral is a total return swap (the consequence of which many investors do not understand) – and it is only a question of time before our industry faces its first major mis-selling scandal related to index trackers.

Finally, in my humble opinion, index trackers are more of a bull market than a bear market instrument. I have argued repeatedly over the past seven years that we are in a structural bear market (defined as a market of declining P/E values). The long-term inflation-adjusted return in a structural bear market is near zero and that is precisely the return UK and US equities have delivered since 2000. I can see the point of tracking an index in a raging bull market where it may be difficult to keep up with markets; however, in markets like these I believe other types of strategies are required.

So what can you do? A few ideas spring to mind:

  • Stick with people, not firms. In our industry the key assets walk out of the door every evening and, if they do not return the next morning, neither should you.
  • Identify an investment strategy you are comfortable with. Whether you believe in value, growth or something entirely different is less important. All active managers have their ups and downs, and it is when the going gets tough that it becomes critical that you are entirely onboard with the fund manager’s investment approach.
  • Prohibit high frequency trading (HFT). HFT uses powerful computers and sophisticated software to take advantage of microscopic inefficiencies in markets around the world. HFT models will often sell a security within a few milliseconds of having bought it. Does that add any economic value to financial markets? I don’t think so. Does it create unwarranted volatility occasionally? I very much believe so. Although I am not in favour of the much discussed financial transaction tax proposed by the Germans and the French, ironically, a modest transaction tax (if it were global) would wipe out all HFT based strategies, and the world would be a better place as a result.
  • Don’t invest in hedge funds for performance reasons. Do it because it is one of the few areas where you can truly diversify your investment risks. For example, the average managed futures fund was up well over 20% in 2008% when most asset classes collapsed.
  • Consider multi-strategy funds as an alternative to funds of hedge funds. The downside is that you concentrate your manager risk but you often achieve better strategy diversification and more attractive returns. Multi-strategy funds outperformed funds of hedge funds by approximately 3% last year and they are on target to do so again this year (see here).
  • Do not disregard sound advice. Those of us who have worked in the industry for decades know where many of the pitfalls are and can help investors stay clear of most of them. Just make sure your interests are aligned with those of your adviser.
  • Or you can simply do as the 1.5 million people in the UK who, according to a survey conducted earlier this year by Schroders, hold all their equity investments in a single company. Not my preferred approach, but who am I to challenge the wisdom of 1.5 million people?

Niels C. Jensen

5 December 2011

© 2002-2011 Absolute Return Partners LLP. All rights reserved.

[1]      Study conducted by Thames River Multiple Capital (3 years through March 2011) and based on the IMA’s All Companies Sector.

[2]      Bestinvest defines a dog fund as a fund that (a) has underperformed in each of the last 3 years, and (b) underperformed their benchmark by at least 10% over the last 3 years.


The Russian financial crisis and eventual default is often cited as a counterargument to one of the principle MR ideas that a sovereign currency issuer should not be able to go bankrupt. It’s a complex subject that is worth spending some time on.

Russia was a rather unique situation. Most people who study the Russian default are fixated on the fact that Russia defaulted on their debt. They focus almost entirely on the ultimate cause of death without actually studying what led to the default. This is similar to studying a man who dies of a heart attack and concluding that his bad heart was what was wrong with him. And while that might be true, a more thorough examination is likely to show you that a series of things (diet, smoking, lack of exercise, etc) actually led to broad problems that ultimately culminated in a heart attack. This lack of analysis leads many observers to conclude that Russia had too much debt, defaulted, end of story. This sort of simple analysis leads to simple conclusions which leads to misconceptions. The truth, as is generally the case, is more complex.

When one looks at the history of Russia you actually find many similarities with my conclusions in “Hyperinflation – It’s More Than Just a Monetary Phenomenon“. In the case of Russia, we actually have many of the same elements leading to hyperinflation and then default. In this particular case, we have loss of a war, regime change, collapse of the tax system, political corruption, foreign denominated debts and collapse of productivity. In other words, from an MR perspective, this country was ripe for self destruction as they met almost all of the criteria that precede a hyperinflation and/or crisis resulting from ceding of monetary sovereignty.

I don’t have nearly the time or the space to cover the sequence of events in its entirety, but it’s important to understand that Russia’s eventual hyperinflation and 1998 default is actually rooted in the break-up of the USSR which occurred in 1991. The dissolution of the USSR was the largest dissolution of any socialist state and resulted in 15 sovereign states. Russia was the surviving state formerly known as the USSR and the burden that accompanied this was extraordinary. As you can imagine, the collapse of one of the worlds super powers was highly traumatic as the government and its people attempted to transition. Here we have the first two common elements in hyperinflations – loss of a war & regime change. The third crucial element was foreign denominated debts from their Soviet predecessors. How problematic was this? Pravda explains how Russia only just managed to pay off this heavy burden a few years ago:

“The Soviet Union left a huge debt after its collapse. Russia became the only country to inherit not only the foreign property of the former USSR, but all of its foreign debts as well. It was extremely hard for Russia to serve the debt because the economy was declining steadily in the beginning of the 1990s. The Soviet debt had been restructured four times before the default of 1998. By 1999 Russia managed to either write off or delay the payments to private creditors (the London Club, for instance). However, such a compromise proved to be impossible with the Paris Club of Creditors.”

From an MR perspective, the story essentially concludes itself right there. This country was never truly sovereign because it was essentially a currency user when the new regime was established and Russia was saddled with the foreign denominated debts of the old USSR. In other words, ceding your monetary sovereignty proved disastrous as we’re now seeing in Europe. But there’s actually more to it than just that. Their errors multiplied as the years went on.

Many analysts and critics of the Russian default like to imply that Russia was simply spending uncontrollably and that their default is an excess of spending and government largess. But that’s not exactly accurate. Turmoil in the regime change and political disunity made tax collections increasingly difficult as the new regime took control. The St Louis Fed cites corruption and the drop in tax collections as the primary cause of the ballooning deficit:

“Another weakness in the Russian economy was low tax collection, which caused the public sector deficit to remain high. The majority of tax revenues came from taxes that were shared between the regional and federal governments, which fostered competition among the different levels of government over the distribution. According to Shleifer and Treisman (2000), this kind of tax sharing can result in conflicting incentives for regional governments and lead them to help firms conceal part of their taxable profit from the federal government in order to reduce the firms’ total tax payments. In return, the firm would then make transfers to the accommodating regional government.”

The country would eventually go to the IMF in 1996 seeking aid. This further relinquished their sovereignty. All the while, inflation was ravaging the country leading to unrest and increased economic turmoil. Their rolling hyperinflation leftover from the trauma of the collapse of the USSR never really ended. Even into the late 90’s the country suffered from high double digit inflation:

The lack of economic diversity (their economy was highly dependent on oil exports) and foreign denominated debts made it vital that they grow via their trade surplus. In attempting to achieve this the country further ceded sovereignty by implementing a peg to the US Dollar. Further, in 1998 the Russian government cited the tax issue as a serious risk to the regime. They attempted a complete overhaul of the tax system, but the damage had already been done. As the Asian Crisis erupted in the late 90’s the fragility of the Russian economy was exposed. The government attempted to protect the Ruble during the crisis leading to massive hemorrhaging of FX reserves. In a 1998 paper Warren Mosler explained the impact of this policy:

“The marginal holder of ANY ruble bank deposit, at any Russian bank, had a choice of three options before the close of business each day.

(I will assume all rubles are in the banking system. Actual cash is unnecessary for the point I am making in this example.)

The three choices are:

Hold rubles in a clearing account at the Central Bank

Exchange ruble clearing balances for something else at the CB.

Buy a Russian GKO (tsy sec), which is an interest bearing account at the CB

b. Exchange rubles for $ at the official rate at the CB

For all practical purposes, 2a and 2b competed with each other. Russia had to offer high enough rates on its GKOs to compete with option 2b. In that sense interest rates were endogenous. Any attempt by the Russian Central Bank to lower rates, such as open market operations, would result in an outflow of $US reserves. The conditions for a stable ruble could not coexist. The net desire to save rubles was probably negative, the failure to enforce tax liabilities resulted in deficit spending even as the government tried to reduce spending, and the higher interest rate on GKO’s increased government spending even more.

At the time GKO rates were around 150% annually, and the interest payments themselves constituted at least the entire ruble budget deficit. It seemed to me that higher rates of interest were the driving factor behind the excess ruble spending which led to the loss of $US reserves.

With the $ in high demand due to a variety of factors, such as domestic taxed advantaged $US savings plans, insurance reserves, pension funds, and the like, and, exacerbating the situation, what could be called overly tight US fiscal policy, there was, for all practical purposes, no GKO interest rate that could stem the outflow of $US reserves.

The main source of $ reserves was, of course, $ loans from both the international private sector and international agencies such as the IMF. The ruble was overvalued as evidenced by the fact that $ reserves went out nearly as fast as they became available. The Russian Treasury responded by offering higher and higher rates on its GKO securities to compete with option 2b, without success. This inability to compete with option 2b is what finally leads to devaluation under a fixed exchange rate regime.”

But that wasn’t all. The global economy began to decline sharply as the Asian Financial Crisis unfolded in 1998. Russia was particularly hard hit as the oil and non-ferrous metals markets collapsed. The shock was enough to drive investors to believe that the Ruble would be massively devalued or debts would be defaulted on. In other words, Russia was built on a poor foundation and then driven into the ground as a series of events battered their economy and government.

In sum, you had a nearly perfect environment for a major economic calamity. And like my study of past hyperinflations, we find that the Russian default was actually much more than just a monetary phenomenon. In fact, it was rooted in much more devastating and complex issues than merely running high sovereign debts. The primary causes include regime change, loss of a war, foreign denominated debt and loss of monetary sovereignty via a pegged currency.

N.B. - It should go without saying that this situation is not even remotely analogous to the current situation in the USA.

Addendum – A brief note on willingness to pay via Warren Mosler:

“An extreme example is Russia in August 1998. The ruble was convertible into $US at the Russian Central Bank at the rate of 6.45 rubles per $US. The Russian government, desirous of maintaining this fixed exchange rate policy, was limited in its WILLINGNESS to pay by its holdings of $US reserves, since even at very high interest rates holders of rubles desired to exchange them for $US at the Russian Central Bank. Facing declining $US reserves, and unable to obtain additional reserves in international markets, convertibility was suspended around mid August, and the Russian Central Bank has no choice but to allow the ruble to float.

All throughout this process, the Russian Government had the ABILITY to pay in rubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, WILLING to make payments in rubles. In fact, even after floating the ruble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be UNWILLING to make payments in rubles when due, both domestically and internationally. It defaulted on ruble payment BY CHOICE, as it always possessed the ABILITY to pay simply by crediting the appropriate accounts with rubles at the Central Bank.

Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ABILITY to meet its notional ruble obligations but was UNWILLING to pay and instead CHOSE to default. “


*  Update – It’s come to my attention that some of the statements in this piece might be somewhat misplaced.  Many different economists have contacted me over the last few months to point out that MMT was not, in fact, the first group of economists to predict the Euro crisis (although that should not detract from the fact that they did in fact predict the crisis). I should also be clear that Wynne Godley was not an MMTer and I should not have implied as much.   Additionally, there are a number of economists who predicted that the Euro would not work and did so well before the MMT economists.  This list has been updated to account for this.  Sorry for the exaggeration.


Being right matters.  This isn’t emphasized quite enough in the finance world and in economics in general.  Too often, bad theory has led to bad predictions which has helped contribute to bad policy.  While MMT remains a heterodox economic school that has been largely shunned by mainstream economists, the modern proponents have an awfully good track record in predicting highly complex economic events.

In the last few years, the Euro crisis has proven a remarkably complex and persistent event.  And no school of thought so succinctly predicted the precise cause and effect, as the MMT school did.  These predictions were not vague or general in any manner.  In reading the research from MMTers at the time of the Euro’s inception, their predictions are almost eerily prescient.  They broke down an entire monetary system and described exactly why its construction would lead to financial crisis if the union did not evolve.

In 1992 Wynne Godley described the inherent flaw in the Euro:

“If a government does not have its own central bank on which it can draw cheques freely, its expenditures can be financed only by borrowing in the open market in competition with businesses, and this may prove excessively expensive or even impossible, particularly under conditions of extreme emergency….The danger then, is that the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression it is powerless to lift.”

In his must read book “Understanding Modern Money” Randall Wray described (in 1998) the same dynamic that led to the crisis in the EMU:

“Under the EMU, monetary policy is supposed to be divorced from fiscal policy, with a great degree of monetary policy independencein order to focus on the primary objective of price stability.  Fiscal policy, in turn will be tightly constrained by criteria which dictate maximum deficit to GDP and debt to deficit ratios.  Most importantly, as Goodhart recognizes, this will be the world’s first modern experiment on a wide scale that would attempt to break the link between a government and its currency.

…As currently designed, the EMU will have a central bank (the ECB) but it will not have any fiscal branch.  This would be much like a US which operated with a Fed, but with only individual state treasuries.  It will be as if each EMU member country were to attempt to operate fiscal policy in a foreign currency; deficit spending will require borrowing in that foreign currency according to the dictates of private markets.”

In 2002, Stephanie Kelton (then Stephanie Bell) was even more specific in describing the funding crisis that would inevitably ensue in the region:

“Countries that wish to compete for benchmark status, or to improve the terms on which they borrow, will have an incentive to reduce fiscal deficits or strive for budget surpluses. In countries where this becomes the overriding policy objective, we should not be surprised to find relatively little attention paid to the stabilization of output and employment.In contrast, countries that attempt to eschew the principles of “sound” finance may find that they are unable to run large, counter-cyclical deficits, as lenders refuse to provide sufficient credit on desirable terms. Until something is done to enable member states to avert these financial constraints (e.g. political union and the establishment of a federal (EU) budget or the establishment of a new lending institution, designed to aid member states in pursuing a broad set of policy objectives), the prospects for stabilization in the Eurozone appear grim.” (emphasis added)

In 2001 Warren Mosler described the liquidity crisis that the Euro would lead to:

“Water freezes at 0 degrees C.  But very still water can be cooled well below that and stay liquid until a catalyst, such as a sudden breeze, causes it to instantly solidify.  Likewise, the conditions for a national liquidity crisis that will shut down the euro-12’s monetary system are firmly in place.  All that is required is an economic slowdown that threatens either tax revenues or the capital of the banking system.

A prosperous financial future belongs to those who respect the dynamics and are prepared for the day of reckoning.  History and logic dictate that the credit sensitive euro-12 national governments and banking system will be tested.  The market’s arrows will inflict an initially narrow liquidity crisis, which will immediately infect and rapidly arrest the entire euro payments system.  Only the inevitable, currently prohibited, direct intervention of the ECB will be capable of performing the resurrection, and from the ashes of that fallen flaming star an immortal sovereign currency will no doubt emerge.”

In a recent article, Paul Krugman referred to some of his predictions as “big stuff”.   What the MMT school has accomplished through its understanding and prescience of the European union is not merely “big stuff” – it is nothing short of remarkable.  This was not merely saying that the Euro was flawed for this reason or that and that the construct of a united Europe was misguided (a prediction made by many at the time of the Euro’s inception due mainly to political biases).  The MMT economists approached the formation of the Euro from a purely operational aspect and predicted with near perfection, exactly why it was flawed and exactly why it would not work as is currently constructed.

Some economists say MMT focuses too much on reality by focusing on the actual operational aspects of the banking system and the monetary system.  But as we have seen time and time again, having a poor understanding of the monetary system is not only detrimental to your portfolio, but detrimental to the millions of citizens who are now being subjected to the ignorance of the economists who influence these monetary constructs.

* Corrected date error in Godley citation.

** I should also be clear that Godley was not an MMTer and was the first post-Keynesian making the Euro comments.  


Let’s not sugarcoat tonight’s “resolution” – this is merely a temporary measure that will buy them more time to resolve the true cause of the currency crisis.  Let’s take a brief look at some of the key points of tonight’s statement (read it in full here):

“All Member States of the euro area are fully determined to continue their policy of fiscal consolidation and structural reforms. A particular effort will be required of those Member States who are experiencing tensions in sovereign debt markets.”

Translation: Austerity will continue.  This is more of the same.  Trade deficit nations undergoing a balance sheet recession will be forced into further budget consolidation which will continue to put downward pressure on growth and ultimately worsen the fiscal picture.  

“We commend Italy’s commitment to achieve a balanced budget by 2013 and a structural budget surplus in 2014, bringing about a reduction in gross government debt to 113% of GDP in 2014, as well as the foreseen introduction of a balanced budget rule in the constitution by mid 2012.”

Translation: they still believe Italy and the other periphery trade deficit nations can undergo austerity, external sector outflows and debt improvements. Greece has already proven this wrong.

“We reiterate our determination to continue providing support to all countries under programmes until they have regained market access, provided they fully implement those programmes.”

Translation: The ECB will temporarily enter markets in order to avoid catastrophe, but will not become the fiscal issuer required to resolve the crisis.

“To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors. The Euro zone Member States would contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks.”

Translation: Greece is the offering to the German austerity Gods. Bondholders will take a haircut on the $120B Greek debt they own, but will also be recapitalized. This is really nothing more than a peace offering to those who want to see the banks “take a loss”.

“Being part of a monetary union has far reaching implications and implies a much closer coordination and surveillance to ensure stability and sustainability of the whole area. The current crisis shows the need to address this much more effectively. Therefore, while strengthening our crisis tools within the euro area, we will make further progress in integrating economic and fiscal policies by reinforcing coordination, surveillance and discipline. We will develop the necessary policies to support the functioning of the single currency area.”

Translation: We know we need a fiscal union of some sort, but we can’t get everyone on board. This is a work in progress.

“The EFSF will have the flexibility to use these two options simultaneously, deploying them depending on the specific objective pursued and on market circumstances. The leverage effect of each option will vary, depending on their specific features and market conditions, but could be up to four or five.”

Translation: A larger EFSF will help to stem the bleeding and reduces the odds of a worst case scenario where we experience a Lehman type event. The leveraging of the EFSF ensures that Europe’s banks will not be allowed to fail and cause massive private sector contagion.

“Financing of capital increase: Banks should first use private sources of capital, including through restructuring and conversion of debt to equity instruments. Banks should be subject to constraints regarding the distribution of dividends and bonus payments until the target has been attained. If necessary, national governments should provide support , and if this support is not available, recapitalisation should be funded via a loan from the EFSF in the case of Eurozone countries.”

Translation: Substantial capital has been set aside in the case of widespread bank failures or recapitalization needs. Again, this fends off the worst case scenario where a massive banking crisis spreads into the private sector.

Conclusion: This is a step in the right direction. By recapitalizing banks and enlarging the EFSF they have set a nice sized rifle on the table. Unfortunately, this is just more of the same in greater size. Ultimately, none of these measures will resolve the true cause of the crisis which is rooted in the currency and the incomplete currency union. Until Europe resolves the imbalance caused by the single currency there is no reason to believe this crisis has ended. I still believe the ultimate resolution here will involve fiscal transfers of some sort directly to the sovereigns that resolves the lack of sovereignty issue. That likely means e-bonds or a central Treasury at some point. We are clearly not there though this statement buys them time.

For now, we can breathe a sigh of relief knowing that we aren’t on the verge of Lehman 2.0. Unfortunately, we can’t expect this to resolve the sovereign debt crisis as austerity will continue and the current measures do not attack the lack of sovereignty issue. All in all, this removes the worst case scenario, but virtually guarantees a muddle through scenario. If budgets worsen on the periphery we should expect to revisit this issue in the coming quarters and the crisis will once again ripple through the market forcing Euro leaders into greater action.  Perhaps a true resolution is not far in the future.  Unfortunately, it likely means more market volatility before leaders realize the true gravity of this situation.