Archive for Special Reports – Page 2


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.



This may very well be the most important data point that we are currently receiving every quarter.  Yesterday’s Z1 released by the Federal Reserve showed a continuing decline in household credit.   The latest reading showed a -2% decline in total household debt growth versus last year.  The Fed summarized the data:

“Household debt declined at an annual rate of 2 percent in the first quarter; it has contracted in each quarter since the first quarter of 2008.  Home mortgage debt fell at an annual rate of 3½ percent in the first quarter, ¾ percentage point more than the decline posted last year.  Consumer credit rose 2½ percent at an annual rate in the first quarter, the second consecutive quarterly increase.”

Total household debt continues to decline

Frustratingly, I’ve been discussing this dynamic for well over 2 years now.  In early 2009 I wrote about why this wasn’t the banking crisis that Ben Bernanke thought it was, why the aid package would likely fail to help Main Street (it focused too much on Wall St) and why we were remarkably similar to Japan:

“Unfortunately, our leaders have misdiagnosed our problem as a banking crisis and not a Main Street crisis.  We have ignored the real root cause of the problem which lies not with the bank balance sheets, but with the household balance sheets.  As I have long maintained, we are looking more and more like Japan and the balance sheet recession they suffered.  While we ignore Main Street in favor of Wall Street it’s likely that the recession on Main Street will endure….”

Being a consumer driven economy this decline in debt remains the most important component of our economic plight.  As I’ve previously explained, the collapse in consumer debt has been the primary cause of weak economic growth.  Consumers took on excessive debt levels during the housing boom and when housing prices collapsed their balance sheets were turned upside down.  Consumers were left with excessive debt, collapsing aggregate incomes and a subsequent balance sheet recession.  The overall result is that consumers are still working to pay down this debt and remain in saving mode as opposed to debt accumulation and spending mode.

This is a highly unusual event that has only been seen on rare occasion in developed economies over the last 100 years.  As this process occurs there is only one entity that can help to stabilize the economy – the US Federal government.  As we know from the sectoral balances, when the private sector is in saving mode and not spending mode (due to debt reduction) and the current account remains in deficit, there is only one sector that can offset this weakness in an attempt to create economic growth.  That is the public sector.  Thus far, we’ve managed to fend off the austerity chatter, however, the risks appear to be on the rise as government officials become convinced that the United States is bankrupt (something that is fundamentally impossible).

This is the exact situation we have seen in Japan for the last 20 years and it is currently occurring in much of Europe.  If the United States implements a policy of austerity there is little doubt that the economy would continue to contract again, unemployment would increase and the economic malaise would worsen.  By my estimates, this situation is likely to persist well into 2012 and perhaps longer depending on how the economic environment progresses.


* Addendum 1 - It’s important to note that the consumer debt reduction process is a good development.  It is necessary to help build the foundation for a sustainable recovery.  Consumer debt accumulation in moderate levels should been seen as a good thing.  Unfortunately, it was the excessive debt binge that caused our current predicament.  As this process heals over the years we should embrace it and accept it as a necessary part of the natural economic progression following a debt bubble.  That requires a unique policy response and a particularly important need to focus on Main Street’s woes and not Wall Street’s woes.

** Addendum 2 – Because monetary policy works largely to increase the debt levels and by helping the banking sector, it can actually be detrimental to this natural healing process during a balance sheet recession.  This is why we should reject further Fed intervention in the markets and encourage Congress to look into potential aid packages such as a reduction in taxes.

*** Addendum 3 – Scott Fullwiler wrote a spectacular piece on sectoral balances here.  This should really help clarify what is going on today.  Scott Fullwiler for Treasury Secretary?  :-)