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.


By Robert P. Balan, Senior Market Strategist, Diapason Commodities Management

This is part 2 of Robert Balan’s “Case for higher oil prices by 2012″.  To read part 1 please see here.  

The physical oil market continues to show a remarkable strength even if futures prices are lagging amid worries about the impact of an economic slowdown on crude oil demand. The latest signals of supply and demand tightness come from Asia and the Middle East. One example: the cost of Oman-Dubai crude, the regional benchmark, in the spot market has surged significantly above the price for delivery into early 2012, as reported recently by the Financial Times.

The downward slope of the forward curve, known as backwardation (i.e., “inverted), is an indication of immediate tightness. Another: the premium that Saudi Arabia charges to Asian refiners for its main crude stream has jumped to an all-time high. The dire macro outlook continues to weigh on the oil futures complex, but there remains very little in the way of weakness visible in the physical crude oil market itself. The first-to-second month backwardation in Oman-Dubai crude – an indicator of physical tightness – has spiked recently to $1.40 a barrel, up from just 7 cents a month ago and about 60 cents six months ago.

The backwardation is among the strongest in recent years. The strength of Oman-Dubai is even
more surprising taking into account that the seasonal peak in oil demand in the Middle East – the
air conditioning season over the summer – has just ended.

Read the full research note here:

The Case for higher oil prices Part 2.1_final


If you cite inflation statistics these days you inevitably run into the same counterpoints from those who have long been predicting hyperinflation in the USA. And despite the fact that there are still no signs of hyperinflation (or even high inflation) in the US economy the hyperinflationists remain convinced that they will one day be right. One of the classic responses that you hear from this crowd (aside from the misleading “gold is higher” argument) is not that they’ve been wrong, but that the data the government uses is “misleading” or “manipulated”. This always leads back to one place – Shadow Stats, which is a website known for recreating certain government statistics such as CPI and M3 in a manner that they claim is more accurate than the “manipulated” government data. The BLS and Shadow Stats had a bit of a back and forth a few years ago over this and several other economists have cited irregularities in the Shadow Stats data. Many others have defended Shadow Stats and their service is more popular than ever.

Now, I don’t necessarily believe that the approach that Shadow Stats uses is flawed. In fact, I think it’s incredibly valuable to have companies and independent analysts reviewing government data. After all, our democracy is dependent upon holding our government accountable. In this regard, the Shadow Stats site contributes a very valuable service.

So while I am not here to claim that the Shadow Stats data is not useful, I do think it’s important to highlight some interesting facts surrounding their application of this data and analysis in recent years. The most glaring is the accuracy of their most famous prediction. Shadow Stats has been predicting hyperinflation for at least 6 years now and every year the forecast gets bumped to the next year. For instance, in 2005 Shadow Stats said government spending was spiraling out of control and would inevitably lead to hyperinflation:

No Way Out — System Doomed to Hyperinflation
The regular, annual $3.5 trillion shortfall in government operations cannot be covered by Uncle Sam; the situation has deteriorated beyond any hope of a solution within the existing system. Raise taxes? Even a 100% personal income tax would leave a deficit. Cut spending? Spending cuts that would bring government fiscal conditions into some semblance of order would be so draconian as to be beyond any political possibility in today’s environment. What remains inevitable — only a matter of time — is a national bankruptcy.

Such circumstances in the past — though no nation on earth has ever come close to experiencing the level of fiscal and financial fraud now being perpetrated on the American people — typically have been “cured” by revving up the printing presses and creating excessive quantities of money. The end result is a monetary collapse in a hyperinflation, with the currency becoming worthless. For a detailed discussion of a possible U.S. hyperinflation as well as a history on the GAAP accounting reports, see “Federal Deficit Reality: An Update” (July 7, 2005). “

The head Economist of Shadow Stats, John Williams, became increasingly vocal about hyperinflation as the years passed. In 2007 he rightly predicted a recession. But the recession he foresaw was a hyperinflationary recession. In 2008 Shadow Stats issued a special hyperinflation report. It said:

“Official CPI could be running in double-digits by year-end 2008….The efforts by the federal government and the Federal Reserve to prevent a systemic collapse as a result of the banking solvency crisis has started to spike broad money growth, as measured by the SGS-Ongoing M3 measure, which currently shows a record annual growth rate of 17.3%. While the Fed has not been formally creating new money — yet — by adding to reserves, it has had the effect of creating new money by re-liquefying otherwise illiquid banks, by lending liquid assets versus illiquid assets. As a result, a number of banks have been able to resume more normal functioning, lending money and creating new money supply. As the systemic bailout proceeds, formal money creation will follow and already may be starting to show up in official accounting.”

Now, from the Monetary Realism perspective there is a whole lot wrong with this picture. The comments on reserves imply that the Fed adds new money via programs such as QE2. Regular readers know this is simply not true and it is why their predictions surrounding the QE’s with impending hyperinflation have been wrong thus far. What we tend to see from hyperinflationists when discussing QE is that the Fed is monetizing the debt and adding substantially to the money supply by adding reserves. In 2010 John Williams said:

“The weakening in broad money growth is despite the initial Treasury-debt monetization in the second
round of “quantitative easing.”

He then showed a very scary chart of the monetary base – the one which depicts a vertical line which would give one the impression that the broader money supply is exploding. The only problem here is that QE is not debt monetization and it is not money printing. We know this because we now have rock solid evidence that adding reserves to the banking system is in no way inflationary – in fact, the money multiplier has now even been rejected by the Fed itself. Because banks are never reserve constrained there is never a need to be alarmed by the Fed’s swapping of reserves for bonds (at least not for the reasons hyperinflationists would have you believe).

Shadow Stats also recreates M3. According to their own data, M3 collapsed in 2009. It has since recovered but remains at relatively meager levels when compared to the period where the hyperinflation predictions started in 2005 when M3 was surging at near double digit levels.

So, when we look back at those 2005 hyperinflation predictions one can’t help but be reminded of all the traders in Japan who have been shorting Japanese Government Bonds since 1990. Or the various economists who have been predicting the inevitable rise of the bond vigilantes in the USA. Some have been making this prediction for decades now. But like the hyperinflationists, they have misinterpreted the actual operational realities of our monetary system and in doing so have made predictions that are unlikely to come true.

On a slightly different note, I always find it interesting how those pushing the hyperinflation theme love to collect U.S. Dollars. For instance, if you visit Shadow Stats you can buy a subscription to their services for a fee – in U.S. Dollars. Now, a hyperinflationist would argue that they are using those dollars to buy hard commodities so that’s a valid point, but the problem is that there are no signs of hyperinflation in the Shadow Stats subscription service. In fact, in real terms, the subscriptions are deflating! If one goes back and reviews the cost of the service it has remained remarkably stable in price:

(Figure 1 from July 16th, 2006)

(Figure 2 from May 12th, 2008)

(Figure 3, from August 28, 2011)

According to the US government inflation should have caused those subscriptions to surge to $197 in 2011. But your Shadow Stats subscription has actually gone down in price since 2006 because inflation has risen a total of 13%+ according to the CPI. Of course I am cherry picking here and I am not showing the data in terms of gold or what could be viewed as a general decline in our standard of living. In fact, I think one could make a good case for the idea that our standard of living has declined since 2006 (not the case since 1913 when the Fed was founded or since 1971 when we went off the gold standard, but that’s a different matter). But you can see the irony regardless.

The bottom line is, no matter how one views all of this data, it’s practically impossible to conclude that the hyperinflation predictions have been remotely true. Perhaps the hyperinflationists will be right in the coming years. But as regular readers know, I doubt that will be the case as hyperinflation has tended to be the result of exogenous factors and not merely the monetary event that many like to make it out to be. The good news here is that hyperinflation forecasts are as affordable as ever so get in while the getting is good (or while the getting is bad?).


By now, we all know that QE2 wasn’t all that effective in helping the economy.   And after extraordinary measures, ZIRP, bank bailouts, endless loans, etc, some are saying that the Fed is completely out of bullets.  Still, like a group of masochists, we are looking to Jackson Hole and Bernanke’s speech to shed some light on what the Fed is going to do next to help get us out of this mess.

I’ve maintained for several years now that monetary policy was going to prove highly ineffective due to the uniqueness of our recession – a balance sheet recession.  Ineffective doesn’t mean useless, but the point is that there are more effective forms of government intervention than the tools the Fed has. In fact, one could argue that the Fed’s primary tool – credit expansion – is detrimental during a credit bubble.  Currently, fiscal policy in the form of a tax cut would be most beneficial given the political environment and the need for cash flow recovery during a balance sheet recession.  But since the Congress appears dead set on blocking any bill that might further “bankrupt” the USA we’re not likely to get any sort of fiscal measures that are going to generate any substantive results.  That leaves us with the Federal Reserve.  So, it might be helpful to review what options they’ve got left (emphasis on might).

What can the Fed do?

1)  Cutting the interest rate on reserves or cutting to a negative nominal rate.

What it means – The Fed would cut the overnight interest rate from 0.25% to 0% or effectively charge a tax on holding reserves or cash.

Will it work?   – As of last night the effective Fed Funds Rate was 0.07.  Cutting it to 0% is essentially meaningless as we’re already there for all intents and purposes.  Charging a fee by setting negative nominal rates would only act as a tax on consumers and/or banks.  Some economists have proposed charging a fee on consumer deposits in order to get them to spend.  But this misses the point.  Consumers aren’t spending because they’re overloaded with savings.  Just like businesses aren’t spending because they’re overloaded with savings.  Both consumers and businesses are suffering from a lack of consistent cash flows that gives them reason to reduce their savings relative to income.  Businesses are lacking revenues via demand and consumers are paying a disproportionate amount of incomes towards debt reduction. Charging a tax on savings is the exact wrong kind of solution for the current environment.  Not only would it reduce consumer spending, but it would filter through to lower corporate revenues.

Charging negative rates on reserves is equally misguided.  This would essentially serve as a bank tax with the idea that this might make banks more inclined to loan money.  But banks don’t lend reserves.  They are never reserve constrained so there’s no such thing as charging them a fee with the hopes that they will “lend their reserves”.  Banks lend when creditworthy customers enter their establishments.   Charging a fee on reserves would only reduce the net interest income to banks while having no impact on overall consumer credit demand.  Again, this would defeat the purpose of trying to boost aggregate demand.

2)  Language change.  

What it means – The Fed would alter market expectations through a change in their statement language.  This is essentially what they did at the most recent meeting when they altered “extended period” to a specific range (2013).

Will it work? - This is confidence fairy economics in my opinion.  I don’t know how this myth of “business uncertainty” has gained so much traction, but the bottom line is that businesses don’t hire because they’re feeling certain about what Fed policy is or isn’t.  They hire when they have higher revenues and an improved operating environment that gives them the certainty of knowing that leveraging their operation will result in a higher return on investment.  Altering the language in the Fed statements can change market expectations and it might even provide businesses with some clarity about the operating environment, but it’s unlikely to make a material impact in the real economy by increasing aggregate demand and ultimately business revenues.  Therefore, I see little reason to conclude that these sorts of language alterations do much more than alter short-term expectations.  Without a fundamental driver to help consumers during the balance sheet recession, this remains a weak policy tool at best.

3.  QE3.

What is means - The Fed would purchase more securities from the private sector.

Will it work?  – This depends on several factors.  There are a lot of different things the Fed could do at this point that would differentiate QE3 from QE1 and QE2.  They could alter duration, buy different assets, target rates, etc.

The one approach I have often discussed (and the primary reason why QE2 failed) is interest rate targeting.  This would involve the Fed setting the long bond rate explicitly.  The Fed would come out and directly say that the 10 year Treasury is 1% or whatever rate they desired.  They would then be a willing buyer of all bonds at that rate.  It would not be about size, but about price.  As I have said before, my fear, is that this would be viewed as pure monetization of the US government’s debt.  And while this view is not technically accurate, perception could have harmful effects via the speculative routes.  If $600B in “monetization” caused such rampant “money printing” fears then just imagine what will happen when the Fed announces that they will be a willing buyer of every single outstanding piece of US debt?  It could make the speculative ramp from QE2 look like child’s play.  Ultimately, I believe this would cause a further margin crunch on consumers as commodities price increases would lead to further cost push inflation.

The Fed could also repeat their actions during QE1.  This is what I initially believed the Fed would resort to during QE2 (because there appeared to be no other transmission mechanism that impacted the real economy).  This could include purchases of agency debt or MBS.  Given the fact that we are beginning to see strains in the credit markets again, this might be a more viable option and could actually be a good proactive move.  But we should be clear.  Like QE1, this would serve only to shore up credit markets and would not necessarily help the economic recovery via improving the state of the US consumer.  So this should be viewed as more of a downside buffer and not a stimulative response.

As I’ve discussed before, the Fed is legally permitted to purchase municipal bonds.  But again, I not only think is unnecessary as the states don’t require aid from the Fed at this juncture, but it would also be viewed as the Fed playing a fiscal role by “funding” the state governments.  Again, I do not think this is political territory that the Fed wants to enter.

The Fed is not legally permitted to purchase equities or corporate bonds at this juncture.  Doing so would require direct aid from the primary dealers or the arrangement of some sort of special purpose vehicle.  I am not sure the Fed is going to begin dabbling in such measures which would cause a political mess and could cause Congress to question the legality of the Fed’s actions.   Under the exigent circumstances clause of the Federal Reserve Act, the Fed could intervene in markets if the downturn were to deteriorate substantially.  But I don’t think we’re at a point where such Fed action would be justified.

The Fed can technically purchase foreign government debt, but is not permitted to bail out a foreign government.  In terms of the Euro crisis, I think the Fed is likely capped at its swap lines.  Again, buying foreign debt would be a messy political environment and the Fed is not in the business of politics.

4.  Making loans directly to banks and businesses.

What it means - Much like the many funding facilities used during the financial crisis, the Fed could re-implement some of the programs to help improve credit access.

Will it work - Again, we’re no longer in a credit crisis, but establishing some of these programs could be a wise proactive measures given the recent flare up in the European banking crisis.  It won’t necessarily prove stimulative, but it could provide downside buffer.  That would be an economic positive as it would remove a substantial downside risk.

5.  Prompting Congress to provide more fiscal aid.

What it means - When Ben Bernanke implemented QE2 last year he petitioned Congress for more fiscal aid.  He could again tell Congress that we are in an unusual predicament, we are not bankrupt, we cannot “run out of money” and we can afford to spend more money to aid our citizens.

Will it work?   Prospects look grim.  A push for a payroll tax cut by Bernanke could gain some traction, but I am not getting my hopes up.*  And unfortunately, I think Dr. Bernanke believes QE is needed to help “fund” this new spending so this idea could be a moot point if he petitions Congress for new fiscal aid and then implements a QE3 programs that sparks a market response that offsets the stimulative effects via cost push inflation.

The bottom line – The Fed has options here though their toolkit is looking depleted.  They certainly have options that could prove proactive in stopping some potential hemorrhaging from any European credit contagion.  But we should be clear.  The Fed’s options in terms of stimulating the economy at this point are extremely limited.  But that doesn’t mean it doesn’t have tools in its kit that could prevent a potential recession from turning into a repeat of 2008.

Dr. Bernanke has to announce some sort of change in policy response this Friday.  The markets are all banking on it now and he has proven time and time again that he’s a believer in the misguided idea that the markets can lead real economic growth.  I don’t believe he can announce anything that will substantially alter the economic landscape, but he’s proven more creative than he usually gets credit for.  Unfortunately, at this juncture, his toolkit is looking pretty limited on the stimulative side.  We’ll reassess his decisions when they’re in writing.

* Edited to correct payroll tax “cut”


* 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.


In a story on his blog today Mark Cuban discussed an idea to get the economy going. Mr. Cuban cites the fact that the US government is essentially borrowing money for free today. Now, we know that an autonomous nation with endless supply of currency in a floating exchange rate system never needs to borrow money to “fund” itself, but the implications of negative borrowing rates are important from a political/logical perspective. It highlights the fact that the USA should essentially be trying to benefit from this odd environment by leveraging itself up on free money. Cuban says the US government should offer loans to corporations willing to hire. This is pretty similar to the MMT jobs guarantee except that it uses the private sector to leverage the government’s resources. I think we should go even further.

America became great for one simple reason. We combined a democratic government with a capitalist economic environment that unleashed creativity, innovation and an unmatched entrepreneurial spirit. We are known for our great innovators. The combination of democracy, freedom and capitalism created an environment where outside the box thinking is rewarded like no other place on earth. What is missing in all of this though is an understanding of how our monetary system could be used to leverage this great system.

The recent market turmoil and extremely low borrowing rates on government bonds only prove one of the basic tenets of MMT – that an autonomous nation with endless supply of currency in a floating exchange rate system never needs to borrow money to “fund” itself, but we have fooled ourselves into believing that we are bankrupt due to the flawed monetary system of Europe or due to misconceptions that lead households to believe that a government balance sheet is somehow analogous to our own. And in believing these destructive myths, we are not actually bankrupting our own government, but we are bankrupting our society by neglecting it of one of its most powerful resources – the government that was created by us for us.

As an autonomous nation with limitless supply of currency in a floating exchange rate system there is no such thing as the USA “running out of money”. But I am not going to convince everyone in the USA of this overnight. And that’s where Cuban’s idea comes into play. This political environment where rates are negative might just be the right environment to convince people that we should be doing more to help this great nation of ours by taking advantage of the fact that we are essentially being paid to lend money to ourselves. It makes perfectly logical sense. Any sensible businessman would agree with the idea that, when people pay you to borrow money from them, you should leverage that loan up.

While Cuban is right that we need more jobs in this country, I think he is missing the key component in the jobs story. We are suffering from a cyclical economic problem that is a balance sheet recession. That can only be fixed by reducing private sector debt levels and getting aggregate demand back to normal levels. And that’s what most businesses are seeing today – a lack of domestic demand. So they’re protecting their margins in an uncertain environment and not leveraging up. Even those corporations who have been taking on extra debt at super low rates have not been turning around to invest because the demand just isn’t there. So, I don’t see why the government lending money to corporations would change any of this to any large degree. We need to get out of the balance sheet recession first.

What I would propose to the US Congress is an Innovation Initiative. As I’ve said before, the structural problem in the US economy isn’t JUST that we’re shipping our jobs overseas. The other side of the coin is that there aren’t more Apple Corps. Let’s create more Apples. And let’s use one of our most powerful resources to do so – the US government.

I believe the Federal Government should allocate ~$50B per year from the Federal budget into what would essentially become the world’s largest private equity firm. While it would be government funded, it could be entirely managed by the private sector. And its focus would be entirely based on increasing private sector output and productivity. I would propose that we hire 10-20 private equity firms to manage the program on behalf of the government. In return, they would get an equity slice in any of the companies that are approved for the Initiative.

I would break the program down into several sectors – energy, environmental, infrastructure, technology, defense, healthcare, etc and allocate a specific amount of funding to each sector via monthly awards ceremonies. We would reward private sector entrepreneurs, start-ups or existing corporations with funding to go out and create new companies, new jobs and capitalize on their vision. I would promote the program vigorously. The key here is to get the creative juices flowing. I want college students sitting in their dorm rooms dreaming of winning this month’s contract. Or boardrooms at major corporations bouncing ideas around about how they’re going to obtain this month’s ~$500MM energy contract. The key here is that we are creating a specific entity funded by the government, run by the private with one sole purpose – to unleash a whirlwind of innovation on the world.

I am sure that much of the money would be “wasted” (at least we’re paying people to do real work as opposed to collecting a paycheck sitting on their couch), but for all the failures we might just look back and say, “wow, that program helped put a man on Mars and helped contribute to solving the energy crisis”. Besides, most new businesses fail. We can’t expect all of these to be winners. Call me crazy, but I see this making an incredible lasting impact on the country despite what ideologues would likely describe as another big government failure….

The USA might be suffering a short-term balance sheet recession, but the problem facing our economy today is much larger. We are suffering from a shortage of Apple Corporations. And we have the resources, talent and entrepreneurial spirit to fix it. We’re just not utilizing the resources and organizing our efforts in a way to benefit from it all because we choose to let politics and ignorance of our monetary system stand in our way….It’s like we’re sitting on a winning lottery ticket and we just refuse to cash it in….

I’d love to hear some thoughts about how insane this idea is or how it could be improved upon….


* 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.

Yesterday’s stock surge off the lows was attributed to comments by several Fed officials who said they are now in favor of the Fed implementing QE3 if the economy continues to deteriorate. I think it would be useful to review what QE2 did and what it did not do.

Now, before we begin it’s important to understand that markets are highly complex dynamical systems. No single policy is going to control these complex systems and it’s impossible to understand whether certain policies would have had differing impacts if implemented differently (or not at all). Therefore, we can only work with the facts we have and the reality that we see before us. This data will work within what has actually occurred and not within what may or may not have occurred without QE2 (such a study would be useless as its findings would be unsubstantiated).

Last year around this time I said quantitative easing would be a great “monetary non-event”. This was based on the idea that QE, as it was being implemented, lacked a transmission mechanism which would allow it to substantially impact the real economy. My prediction that it would matter very little to the real economy and my ideas that it was not “money printing” or “debt monetization” were all met with a great deal of controversy as these ideas were well outside of the mainstream beliefs. With a full year of data in the bag we can judge QE2 pretty definitively.

What QE2 did not do:

It did not help house prices:

It did not reduce the cost of a conventional 30 year mortgage:

QE does not appear to have substantially altered corporate bond rates:

It did not cause the consumer to go on a spending binge:

It did not cause an increase in hourly earnings:

It did not cause businesses to go on an investment binge:

It did not work through the traditional monetary policy channel of increasing loans:

It did not cause real growth to surge:

This is all consistent with my initial argument before QE2. My beliefs were based primarily on the idea that there was no real transmission mechanism through which QE2 could positively impact the real economy. It would not alter the net financial assets of the private sector, altering bank reserve balances would not increase lending and it would not work through portfolio channels in any positive manner due to the balance sheet recession. I believed the result would be little to no real impact, ie, being a “monetary non-event”. But before we make any sweeping conclusions let’s look at what QE appeared to do.

So what did QE2 do?

We know definitively, that the program was misinterpreated by most as “money printing“, “debt monetization” and other terms that implied that hyperinflation or even high inflation were on their way. It’s pretty clear now that that is not the case, but that didn’t stop markets from reacting strongly. We know, definitively, that speculative actions in the markets increased. (Some of these data points are controversial, but again, we are working within the reality that we can see and not what we believe to be true. Correlation does not equal causation, but this should provide us with a fuller picture nonetheless.)

NYSE Margin debt exploded at a 35%+ YOY rate during the program:

It also appears to have helped stabilize the equity market:

We all know that commodities including oil and gasoline prices surged during QE2. I don’t believe it’s a stretch to assume that the massive increase in leveraged speculation coincided with an eagerness to protect one’s self from what was believed to be a highly inflationary environment. This is consistent with a surge in commodity prices.

It helped fuel higher headline inflation:

Gasoline prices played a particularly important role in the surge in inflation:

QE also appears to have had a negative impact on the US Dollar. This is consistent with the idea of monetary easing:

What’s so interesting about all of this data is that the real world data appears to have deteriorated while the data from some markets appears to have improved. In commodity markets we saw massive price increases that did not coincide with subsequent growth in the US economy. Now, some of this effect could be due to overseas growth, but as the BOJ recently reported, I don’t think we can entirely rule out the idea that investors substantially increased their speculative bets during the QE2 program which influenced market prices. The margin data would appear to confirm such thinking.

What we got from QE2 was essentially one huge margin squeeze on the economy as investors protected themselves from inflation via their market hedges (helping contribute to cost push inflation via commodity prices), but saw little to no real-world impact (no offsetting substantive increase in hourly earnings). The result was an increase in inflation and inflation expectations, but no positive follow-through in the real economy to offset the negative effect of the cost push inflation.

Interestingly, this policy gets right to the heart of the discussion that was started the other day by Scott Sumner with regards to MMT and its intense focus on the real-world. Mr. Sumner said:

“I wasn’t able to fully grasp how MMTers (“modern monetary theorists”) think about monetary economics (despite a good-faith attempt), but a few things I read shed a bit of light on the subject. My theory is that they focus too much on the visible, the concrete, the accounting, the institutions, and not enough on the core of monetary economics, which I see as the ‘hot potato phenomenon.'”

This is the line of thought that leads so many to misinterpret QE and its effects. Efficient market thinkers make little distinction between the real economy and the markets. Markets after all, are believed to be good representations of the real economy. This feeds into beliefs like “wealth effects” and the idea that the Bernanke Put is good for the real economy. But as I’ve previously described, markets are anything but efficient. And the markets most certainly are not perfect reflections of the real economy.

I won’t rehash all of the actual monetary operations and the operational realities of QE, but the critical flaw in QE2 is that it had no real transmission mechanism through which it could fix a balance sheet recession and solve real world problems. Instead, it’s largely based on the myth of “wealth effects”, altering real interest rates (which most consumers and business have little to no awareness of), portfolio rebalancing effects and altering expectations.

Clearly, with stocks substantially higher than they were a year ago and the economy more fragile than it was when the program started, I think we can confirm that Robert Shiller was indeed correct about the effect of an equity market wealth effect – it’s highly overrated.

Altering real interest rates and portfolio rebalancing are fanciful sounding in an academic study, but in the real world consumers and business owners have little perception of real interest rates. Particularly during a balance sheet recession. What alters consumer spending habits is their spending desires relative to real earnings. In the case of QE2 we saw a decline in real earnings and a jump in inflation. This is consistent with consumers experiencing a reduction in their standard of living and it is not surprising that we have seen very weak consumer data in recent quarters as a result.

What primarily alters business investment is whether or not they have customers walking in their doors. Because QE did not alter the net financial assets of the private sector (it is merely an asset swap) it did not provide consumers with more spending power which would lead businesses to increase investment. More importantly though, real rates are most effective when they cause a releveraging effect in the economy. And herein lies one of the primary problems with monetary policy during a balance sheet recession. Consumers don’t want to take on more debt! So businesses might refinance, but without the increased business there is no reason to expect them to increase investment. These facts are abundantly clear from the above data on private investment and personal consumption.

Altering expectations appears like pie in the sky economics to me. I don’t deny that there is a certain level of truth to the idea that animal spirits play an important role in the economy, but they cannot be altered via the Fed bond purchases as we experienced during QE2. The problem here is that the majority of consumers and businesses make very few of their daily decisions based on the fact that the Fed might be buying some more bonds. Because this operation does not alter the net financial assets of the private sector there is very little reason to believe that it will filter through the economy in any sort of meaningful way. So, as I’ve often said, QE2 was implemented in a manner that is similar to telling your blind child that he/she might become a world class archer one day. It builds up hope, but doesn’t follow through with any real fundamental effect that will help the child achieve the dream you have implanted in his/her mind.

The various Fed banks and several academic studies have been released over the duration of the program that focus on the events themselves. These “event studies” include data on the days when the NY Fed was actually involved in buying bonds. I have previously argued that these studies are nothing more than datamining based on efficient market hypothesis. But markets are far more complex than this and are not nearly as efficient in their price discovery as some might think. An example of event studies might lead one to conclude that a particular stock’s earnings do not matter because the stock tends to decline in price on the day that they report their earnings. Of course, that would be a nonsensical thing to conclude, but a carefully devised event study could be framed in such a manner so as to provide credence to such a theory. These “event studies” ignore substantial market data over the course of QE2 and imply highly efficient markets. This is grounds for deep skepticism in my opinion.

In terms of its real effects QE2 could have actually been more of a drag on the economy than a form of stimulus. We know for a fact that the Federal Reserve turned over $73B in profits to the US Treasury in 2010 alone. That is largely interest income that is being taken away from the private sector as a result of their massive balance sheet expansion. Remember, this is interest income that the banks could have been earning. Instead, they are receiving 0.25% paper in exchange for their much higher yielding securities. QE does not add net financial assets to the private sector so the net financial drag appears to have been quite substantial.

It’s also important to quantify the effect of the surge in commodities when compared to the fiscal stimulus enacted at the end of Q4 2010.  We now know that Ben Bernanke believed that QE2 was necessary to help finance the extra spending.  Of course, MMTers know this is nonsense as an autonomous monetary issuer in a floating exchange rate system never “finances” its spending.  So, what’s interesting is that QE2 could have actually resulted in a tax hike via commodity prices.  Back in February I mentioned that there was a likelihood that gasoline prices would surge into the summer months.  This was worrisome because gas prices had already rallied into this strong seasonal period.  At the time I wrote:

“If gasoline prices were to average $3.75 by this summer it would be the equivalent of wiping out the entire tax cut that was recently passed.  If prices were to surge back to their 2008 highs it would be the equivalent of a $182B tax on the consumer since QE2 began.”

This indeed happened and it the consumer is now feeling the pinch.  It appears as though QE2 may have actually contributed to offsetting the entirety of the payroll tax cut enacted at the end of last year.*

In sum, it appears as though the positives (wealth effect, portfolio rebalancing and lower US dollar) were more than offset by the many negative trends that persisted. I am a bit surprised by the fact that some Fed officials are weighing another go at QE. The data appears undeniably weak arguing in favor of further “experimental policy”. We have had our experiment and it did not work. What is the point of trying it again? And have we considered the possibility that it could actually makes things worse? As a risk manager, this looks like an awfully bad bet to me. Granted, Dr. Bernanke isn’t in the business of portfolio management, but he is in the business of creating price stability and full employment. I don’t see how this program helps him achieve these goals.

What about QE3?

Now, the Fed could implement QE3 in various ways that would differentiate is from QE2. They could pin long rates and essentially define an inflation rate (this is essentially what the quasi monetarists are arguing in favor of, however, they reject the notion of the balance sheet recession so I think they’re still missing the key element in this economic downturn). Or they could buy other securities. I have trouble concluding that the risks here outweigh the rewards. There is no need at this juncture for the Fed to purchase other securities from the banks. Playing market maker in 2008 was effective. I said it would be at the time. But this is a very different environment. We don’t need the Fed to stabilize the mortgage market. What we need now is real help to the US consumer. Buying more securities at this juncture will only further increase the profits to the Fed which will reduce the net interest income to the private sector. This is entirely unnecessary at this juncture.

The other strategy that is often discussed is pinning long rates. This would certainly “work”. By “work”, I mean that the Fed can achieve any rate across the curve that it desires. All it needs to do is name a price and not a quantity at a specific duration and tell the market that it will protect this rate. The failure to do this has been one of the primary arguments I have used against QE2 since its inception. QE2 could never alter rates meaningfully because it was implemented incorrectly by targeting size and not price. But the risks with this approach are enormous in my opinion. Imagine the market’s response to the idea that the Fed is a willing buyer of however many bonds it needs to buy to achieve a 2% 10 year rate? If you thought the speculative ramp after QE2 was bad I hate to imagine what would happen after this. The debt monetization and money printing articles wouldn’t come off the presses fast enough. This could, in my opinion, only exacerbate the margin squeeze we have seen in recent quarters.

What can be done?

At this juncture, I think we have to recognize that monetary policy has failed us. This does not mean that monetary policy has been entirely ineffective. It just means that it has been far less effective than other possible tools. In terms of the various monetary tools, QE2 appears to have been a particularly ineffective policy response.

Dr. Bernanke would best serve the American people by going to Congress and explaining to them that we are suffering from an extraordinarily rare disease that he simply does not have the tools to combat. He should urge Congress to understand that it is impossible for the USA to “run out of money” and that this debt ceiling charade has been a failure to understand our monetary system. With very low core inflation he should explain to Congress that they can afford to help their constituents more. He should urge them to understand that we are nothing like Greece in that we can’t “run out of money”, but that austerity could make our economy appear similarly weak. He should urge them to pass an immediate full payroll tax holiday and help alleviate the burden on the debt laden consumer. It won’t solve all of our problems, but at this point it’s better than throwing more monetary policy at the wall hoping that it will stick. Perhaps most importantly, Dr. Bernanke needs to understand that further fiscal policy does not need the aid of monetary policy as QE does not serve as a “funding” source for the US government and could actually offset fiscal policy via other negative channels.

* This section was edited on 8/4/2011


In a recent story I pointed out that Richard Koo said it was not significant that the USA has been faster to respond to the current balance sheet recession.  Now, he was primarily referring to the ineffectiveness of monetary policy during a balance sheet recession and the fact that it doesn’t matter how quickly you cut rates or implement QE during this sort of recession.  I largely agree with these comments.  But I think it’s important to note that the USA has a slightly different form of balance sheet recession and is responding to it with fiscal stimulus more quickly than the Japanese did.  This, in my opinion, is unlikely to result in a balance sheet recession as long as Japan’s.

Just to review – it’s important to note that Japan’s debt crisis existed primarily at the corporate level.  In his superb book, The Holy Grail of Macroeconomics, Koo explained the situation:

“Indeed, this leverage issue was another reason Japanese firms moved to pay down debt during the 1990s.  Exhibit 2-2 shows leverage ratios at Japanese and US firms.  Japanese businesses used to be extremely dependent on debt financing relative to their Western counterparts.  In the first half of the 1980s, for example, leverage ratios at Japanese firms were five times those at US corporations.  But no one thought twice about this at the time, because the economy was rapidly expanding, and asset prices were surging higher.  Few were worried about debt levels under these circumstances.  After all, the use of borrowed money to acquire assets raises few eyebrows as long as the economy is expanding and the value of corporate assets is rising.  If anything, companies were commended for taking on more debt because greater leverage translated to a higher return on equity.

But this cycle began to reverse when the bubble burst in 1990, and the Japanese economy entered a period of low growth and falling asset prices.  Companies carrying heavy debt loads still had to service this debt even as earnings declined, putting their survival in jeopardy.  In effect, firms had to pay down debt starting in 1990 not only to put their balance sheets in order, but also to bring leverage down to a level benefitting an era of lower growth.  In this sense, too, Japanese firms have made substantial progress in reducing leverage over the past 15 years.”


These are very important points.  You could essentially replace “households” with “businesses” in the above paragraph and you’d be describing the situation in America today.  And that’s the exact difference.  Our balance sheet recession is a household debt crisis whereas Japan’s was a corporate debt crisis.  As I’ve often said over the years, effective policy needs to focus on households and not banks.  This was always a household debt crisis and not a banking crisis. And while America’s banks are still distressed (although they’re in far better condition than they were in 2008), American businesses are actually very healthy today and I think that is proving to cushion the downside during this recession.

As you can see from the above chart Japanese businesses were grossly overleveraged.  And while US households suffered a massive bubble the leverage was nowhere near the same levels.  If we look at household liabilities to disposable income we can see that the problem is by no means good, but it is becoming more stable by the day:


This is a large part of my estimate for 2013/14 being the end of the balance sheet recession.  Given recent trends, the cash flows of households should begin to support organic recovery long before the de-leveraging was done in Japan.  While we are likely to suffer several more years of weak growth we don’t yet need to fear another lost decade.

Further supporting this theory of a shorter balance sheet recession is US house prices.  Richard Koo notes that Japanese corporations were struck by declining asset prices.  The fact that they had an equity AND housing bubble at the same time served as a double whammy in this regard.  The USA, on the other hand, suffered the equity market bubble more than 10 years ago.  So the impact in recent years has been more concentrated on the collapse in real estate prices.  As I’ve previously noted, I think the majority of the price declines are behind us in housing.  This is confirmed by price trends in Japan as well (see below).  This should stop the uncontrolled bleeding that has caused so much imbalance in recent years.

Lastly, the USA was faster to implement the all important fiscal policy that Richard Koo prescribes.  Contrary to political fearmongering and claims that fiscal stimulus has destroyed jobs, the CBO and the sectoral balances prove that fiscal stimulus has aided in helping the household sector during this de-leveraging (common sense is all it should really take to understand this, but politics and confirmation bias cloud people’s judgment).   This “recovery” has been largely stimulus driven.  It has not been organic by any means, but that is the nature of the balance sheet recession.  If government doesn’t fill the spending void, the bad decisions of the few who caused the debt bubble end up causing the rest of us to suffer a depression alongside them.

In the USA President Bush actually initiated fiscal stimulus before the crisis really hit.  In February 2008 he implemented the Economic Stimulus Act of 2008.  This was obviously not that effective, but was followed up by the massive stimulus package after the collapse (please see the bipartisan CBO’s details on the effects of the stimulus).    The Japanese, on the other hand, did not implement fiscal policy until almost three years into their crisis.   Over the ensuing 6 years Japanese stimulus was a stop and start process with political bickering inbetween (which is beginning to ring all too familiar as our politicians bicker over the debt ceiling).

Most importantly, we have not allowed ourselves to be talked off the edge of the cliff by those who fear the USA is going bankrupt.  Unfortunately, the risk of fiscal austerity poses a serious threat to my optimistic end date for the balance sheet recession.   I am probably naively hopeful that austerity turns out to be less negative than some currently think, but I do acknowledge that this is an enormous downside risk.  As Warren likes to say, “because we think we are the next Greece, we are becoming the next Japan”.  I sure hope not.


By Comstock Partners

Looking back at the long history of the U.S. stock market it is clear that there are long periods when the trend is distinctly up or down.  We call these long trend “secular” markets as opposed to the commonly-known cyclical market trends that last about four years on average.  In our view we are currently in a secular bear market that began when the market peaked over 11 years ago in early 2000.

The most powerful secular bull market took place in the 18-year period from 1982 to 2000.  In this period the market rose from 777 on the DJIA to almost 12,000 (16% compounded/year); the S&P 500 from about 100 to 1550 (16% compounded/year); and the NASDAQ from about 160 to 5050 (22% compounded/year).    Although there were two other powerful secular bull markets such as the periods from 1921 to 1929 and 1949 to 1966, the bull market of 1982 to 2000 was the most significant by far.

S&P 500

Nasdaq Composite

Dow Industrials

The last half-decade of the 1982-2000 advance was accompanied by arguably the most spectacular financial mania of all time.   Stocks, most often in the technology sector, typically went public and tripled on the first day of trading.  The so-called stocks often had no earnings while others were merely concepts that didn’t even have revenues.  To justify the ridiculous prices of these stocks, analysts came up with new and untried metrics such as the number of eye balls that were viewing or would be viewing their websites rather than fundamentals such as earnings or cash flow.

Starting in the late 1990s Comstock constantly warned clients how sick the mania had become.  We did this through lengthy bi-monthly reports in print and later through brief comments on our website.  Although we were too early, our judgment was finally vindicated for all of the right reasons once the stock market finally peaked in early 2000.  At that time we were convinced that the market was entering a secular bear market that would last for many years.  The combination of the extremely powerful 1982-2000 bull market accompanied by a senseless financial mania was the recipe for the start of the secular bear market we envisioned.

You would have to think this secular bear market would be extremely severe with the combination of a major bull market followed by a financial mania.  The market did decline by about 50% but the powers that be did whatever possible to delay or reverse the secular bear.  Fed Chairman Greenspan tried to stop the severe stock market decline by lowering the Fed Funds rate to 1% in mid 2003 and keeping it at that level for a year.  This move stopped the bear market in its tracks.  The low rate enabled home prices to accelerate to the upside, and congress jumped in to help the Fed with the rescue by passing every law they could to make it easy for virtually anyone to buy a home.

This started the housing market on a tear (or bubble) since anyone who wanted to buy a home was able to do so by putting up little, or no money.  Many of these loans were called “no doc” loans which meant that there was no documentation (like annual salary) required in order to get the mortgages approved.  This caused a housing mania that was exacerbated when investment banks packaged the loans and sold them to their clients.  They wound up selling packages of very poor quality mortgages (sub-prime) called “collateralized debt obligations” (CDOs) and convinced the rating agencies (who were paid by Wall Street) to rate these “securitized mortgages” AAA.  To make things worse, most of the brokerage firms that understood the toxicity of these CDOs protected themselves by buying “credit default swaps”, which were paid off when the loans defaulted.

Now, if the most significant bull market in U.S. history, that drove the stock market to “nose bleed” levels, followed by a dot com financial mania wasn’t enough to start the secular bear market, what would?  Well the market did drop by about 50% in 2000-2003 and was on its way to completing the secular bear.  But, when the Fed induced a housing market mania accompanied by a cyclical bull market in stocks (within a secular bear) you would think that when the secular bear resumed it would be more severe and deeper.  So far, it did produce another 50% decline in the stock market in 2008 and early 2009 as a credit crisis in 2007 caused the worst recession since the Great Depression.

The major 50% decline in the market also fit the same path as Japan as one of our “special reports” discussed in 12/2/2010 “Is America Following the Same Path as Japan?” Japan “hit the wall” after experiencing a similar stock market move from 1972 when the Nikkei 225 was trading about 2000 until the end of 1989 when it reached over 39,000 (18% compounded/year).  If you recall it was in the late 1980s when everyone believed that Japan would take over all the manufacturing in the world.  At one time the U.S. had a robust TV industry until Japan essentially took over the industry and made virtually every U.S. TV in the late 1980s.  This move up in Japan was driven by excesses in the non-financial corporate debt side.  That was when Japan corporations bought Pebble Beach and Rockefeller Center and anything else that was for sale.  Japan paid the price for the excess debt- driven bull market that drove the Nikkei to almost 40,000 and now is under 10,000 over two decades later.

Nikkei 225

The key 18 year bull market we experienced here in the U.S. ending in 2000 was driven by excesses in household debt. Although wage growth had flattened out, consumers wanted a larger home, a nicer car, and nicer clothes whether they could afford it or not.  If they ran out of money with their credit cards and bank loans they would take out a second mortgage on their homes that they felt could never decline in value. Household savings rates, which usually averaged about 9%, fell to near zero.  Household debt as a percentage of GDP generally averaged about 50% of GDP and 65% of personal disposable income (PDI).  However, starting in the early 1980s (as the stock market started this amazing bull market run discussed earlier) household debt rose to 100% of GDP and 130% of PDI by 2008.

Once the secular bear market started in 2000 we were convinced that the U.S. public had learned their lesson and would start to pay down their debt and begin saving again.  We were wrong.  After Greenspan lowered rates and started another financial mania driven by home values and the stock market, we were again convinced that the public couldn’t be fooled again.  However, after enormous bailouts of the largest financial institutions in the country, as well as the auto industry, and even more monetary ease than in 2003 (accompanied by TARP, the stimulus plan, QE, and QE2); we started another cyclical bull market within the secular bear market.   The stock market went from severely oversold in March of 2009 to gaining 100% from those levels.  We are convinced that, after the latest 100% rally since March of 2009, that this was the last time the public could be fooled again.  And this time we are able to determine that consumers are saving more and consuming less; we believe this change in attitude will continue for a long period of time, creating severe headwinds against strong economic growth.

The most important question to ask yourself is, “can we have another major bull market in U.S. stocks anytime in the near future?”  We believe the answer is a resounding “NO”!  Just look at what took place in Japan after their stock market and economy “hit the wall” at the end of 1989.  The private sector corporate debt that was primarily responsible for the most significant bull market in Japan’s history continued deleveraging for decades.   Government debt rose in order to replace the shrinking of the non-financial corporate debt (the debt that drove their bull market) that was either defaulted on or paid off.  If the non financial corporate debt drove the market up during their great bull market, it only makes sense that their stock market (Nikkei 225) would decline as the deleveraging process was taking place.  And that is exactly what has been taking place for the past 21 years (since 1989) as the Nikkei declined from almost 40,000 to under 10,000 where it is presently. We also note that during the past two decades Japan’s GDP grew at an average annual rate of only 1%.

Why would we expect any different outcome in the United States as the household debt sector (the main sector that rose and drove the U.S. bull market of the 80s and 90s and also continued adding to the debt as the housing market took off from 2003 to 2007) is still in the process of deleveraging since 2007?  That is just a little over 4 years, and we can expect a continuation of deleveraging for many years to come-we have a long way to go in order to get back to the levels of household debt relative to GDP or Personal Disposable Income (PDI).  (See attached below)

The U.S. stock market will not be able to rise in a sustained manner if we are correct in believing that U.S. households will continue deleveraging for the next few years to as many as 10 more years.  The key is that household debt will have to decline to the levels of the 1950s, 1960s, and 1970s of 50% of GDP and 65% of PDI.  That would mean the weak consumption will continue and that should lead to disappointing economic growth.  The average growth in consumption over many years grew at about 3% and over the past 13 quarter’s consumption only grew by about ½% per year-that is the lowest growth rate since the Great Depression.

So the next question is, “How will the deleveraging affect the economy? And how will a weak economy affect corporate earnings? ”  If the deleveraging affects the U.S. economy  the way Japan’s deleveraging affected their economy over the past 21 years, it will clearly be highly negative  for U.S economic growth.  Since GDP growth and profits are positively correlated over time that should negatively affect corporate earnings that have driven the stock market up for the past couple of years.

Now that operating earnings estimates for the S&P 500 have risen to the record levels of $100 again, we suspect that the deleveraging and weak economy will affect this estimate in a similar vein as in 2008, when S&P 500 earnings estimates were over $108 as into May of that year.    Actual earnings came in at less than $50 for operating earnings and less than $15 for “reported” earnings.

The bottom line is that we expect U.S. stocks market to stay in the secular bear market that started in 2000 for many years to come.  We believe that main factor that drove the most significant bull market in U.S. stock market history (household debt that enabled unrestricted consumption of everything from goods and services to homes) will reverse and continue the deleveraging process that will more than likely continue for a very long time.  This deleveraging will act to affect the stock market in the exact opposite manner as the leveraging did in the bull market.  To quantify this, if we were to look at historical household debt relative to GDP and DPI we would expect the debt to be in the area of about $7 to $7.5 trillion.  Instead this debt rose to about $14.5 trillion at the peak in 2008.  We expect this debt to fall below $10 trillion. That could take many years and be very painful for our economy and stock market.