“In other words, the Great Recession did not emerge because of the collapse of the housing market in early 2006.  Something else had to happen about 2 years later to turn a sectoral recession turn into the Great Recession.  As the figure above suggests, I see the evidence pointing toward a failure by the Federal Reserve to stabilize nominal spending and by implication nominal income. This failure meant that nominal income growth expectations of about 5% a year assumed by household and firms when they signed nominal debt contracts would not be realized.  A debt crisis was therefore inevitable. “

This actually makes some sense, but
doesn’t nullify either the cause of the recession or the resulting balance sheet recession.  Let’s connect the dots here because Beckworth is entirely accurate that nominal spending declined as a result of increased consumer uncertainty and a lack of government action.  I just don’t believe he’s providing a totally unbiased perspective of how things actually unfolded and what the proper response could have been.

The housing bubble had an enormous impact on the consumer psyche and the economy as a whole.  As the consumer’s largest asset and 70% of total private sector debt, the real estate market is an incredibly important component of the US economy.  When this market experiences extreme distortions in pricing it causes a massive ripple effect throughout the economy.  As prices surged in the early half of the 2000′s American’s felt rich.  Their net worth surged and spending was robust as a result.  But let’s look at what precisely unfolded as housing began to contract.

The following graph shows household net worth and real estate prices.  It’s clear that the housing peak led the total decline in net worth.  But that doesn’t tell us much.

What the housing peak did was create uncertainty for consumers.  After years of surging asset prices and exploding net worth, their balance sheet was suddenly stagnant.  We can very clearly see that there is a correlation between expenditures and net worth.  As Americans saw their net worth surge they were happy to spend.  But as the housing market peaked in the consumer suddenly saw their net worth dented.  Spending slowed with the expansion in net worth.  Importantly, it’s the rate of change that matters here.  As the bubble slowed, peaked and then declined this slowly worked its way through consumer behavior as can be seen in the chart below:

It’s very clear that real estate led this slow-down  in overall expenditures.  In fact, the rate of spending declined just after the real estate market peaked and Americans began to feel less wealthy:

This uncertainty in the consumer balance sheet resulted in a slow-down in the rate of overall spending resulting in reduced aggregate demand resulting in a slow-down in corporate revenues resulting in a slow-down in hiring trends.  You can clearly see that the rate of non-construction hiring correlated very highly with the peak in housing.  This is also consistent with the rate of expenditures as seen in the figures above.  In other words, hiring OUTSIDE of real estate started to slow as housing prices peaked.   This makes sense as consumer behavior changed, aggregate demand slowed and expenditures began to slow as well.  Beckworth uses the headline payroll figure to prove his point that construction employment and real estate didn’t lead to the collapse.  It’s misleading at the very least.

This is interesting to me for several reasons.  The most glaring of which is the market monetarists disconnection with reality (they claim MMTers focus too much on reality).  The idea that the real estate collapse did not have a dramatic impact on the economy defies logic.  Perhaps more importantly is the lack of real-world understanding and consumer psyche.   This seems to be a common trend in the academic world and not solely a market monetarism problem.  Instead of looking at how slowing trends lead to a slow, but certain change in consumer behavior, economists too often look at hard data such as nominal peaks in data.  But it wasn’t the nominal peak in spending or housing that necessarily impacted consumer psyche.  It was the rate of change!  This is very clear in the data above.

More importantly, what this data shows is that it was the change in balance sheets that led the decline in spending and ultimately crushed the economy.  As the disease slowly worked its way through the system ultimately poisoning the banking system the collapse was swift.   But the cause is clear.  Whether the Fed could have materially altered that is up for debate.  We know that QE does not alter the net financial assets of the private sector so the argument that the Fed had many weapons at its disposal in 2008 appears fairly weak.  If, on the other hand, the government had been prepared to provide a buffer via increased government spending (perhaps tied to the rate of unemployment) then we would have seen a materially positive change in the balance sheets of households which would have aided them enormously during the asset price decline and de-leveraging.

The bottom line – the real estate bubble and the ensuing collapse in household balance sheets mattered – enormously.  What is up for debate is whether the Fed could have implemented proactive policy that would have helped avoid the collapse.   Considering Fed ops deal in changing the composition of private sector balance sheets (as opposed to amount of net financial assets) I am highly skeptical that the Fed was nearly as powerful as the market monetarists presume….

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.

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 MMT 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 MMT 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. “

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.

“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.

“The conditions that held in 2007 have been replicated, and the next GFC is just waiting for a trigger. The bailout has increased the linkages among the top four or five banks, making the system even more fragile.We’ve lost eight million jobs, opening a demand gap of about $1 trillion.Although some households have defaulted on their debts, and others have repaid portions of theirs, most of the household debt held in 2007 still exists (Figure 4).”

“Against this background, there are multiple events that could trigger a new, potentially deeper crisis. Should information leak out that one of the major US banks is insolvent (a proposition believed by many analysts), another massive liquidity crisis would be likely. Alternatively, the problems could start in Europe and ripple into the United States: for example, there is a plausible path that can be traced from US money market mutual fund holdings of eurobank assets (i.e., $3 trillion of extremely short-term liabilities that are like deposits but not insured) to a new global financial shock. Last time, the US government extended its guarantee to all of them; Dodd-Frank now outlaws such intervention. So the appearance of a problem among eurobanks could bring down that whole market—which is about twice the size of the US subprime mortgage market that brought on the global financial crisis last time.

Far-reaching reform along the Minskyan lines traced above will likely be conceivable only in the aftermath of the next crisis. Unfortunately, that opportunity may be right around the corner.”

Source: Levy Institute

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

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 HyperinflationThe 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 an MMT 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). And because the Federal government of the USA is not “financed” by bond sales, there is no such thing as the Federal Reserve being able to “finance” US government spending (if this all sounds crazy to you I suggest you see here).

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?).

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”

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 monopoly 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 monopoly 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….