Archive for Special Reports – Page 2


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?  :-)


*The following comes to us courtesy of Lance Roberts, CEO of StreetTalk Advisors:

Dow 20_000 – Probably Not Anytime Soon



Joseph Schumpeter is famous for coining the phrase “creative destruction”.  He described it as a  “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.”  This is a necessary component of capitalism.  The strong survive and the weak die.

A new paper out of the University of Alberta by Claire Y. C. Liang, David McLean, and Mengxin Zhao finds that creative destruction has been on the rise in the USA over the last 50 years.  Despite increasing concern over the size of our government and what many refer to as “central planning” the facts actually show that US companies are becoming more dynamic.  They conclude:

“The rate of creative destruction among public firms increases in the U.S. during the period 1960-2009. We document statistically significant increases in big business turnover, changes in market share, the difference in growth rates between firms that gain and lose market share, and other measures that show an increasingly dynamic economy. The increase in economic dynamism is driven by increasingly fast-growing firms that exhibit increasingly high growths in total factor productivity, value-added, and profit margins, and have increasingly high R&D spending and patent grants. The type of firm that generates this creative destruction changes during the sample period. Creators are increasingly smaller and younger, and increasingly issue shares and debt; the average creator would have run out of cash by year-end had it not raised capital, and this financial dependence increases throughout the sample period.”

Perhaps most interesting in this discussion is the lack of creative destruction in the world of banking.  I am generally in favor of deregulation, however, with regards to the financial industry I think a different approach is required due to the importance of this industry to overall US economic stability.  As we now know, this industry has the ability to cause massive instability.  And in one of the great ironies of economic history, deregulation led to what should have been massive creative destruction of our banking system in 2008.

Despite evidence showing that the US economy is becoming increasingly dynamic due to creative destruction, we have recently avoided this natural market process by saving the banks.  And while Wall Street thrives, Main Street continues to struggle.  Perhaps a bit more creative destruction in 2008 wouldn’t have been such a bad thing after all?  Unfortunately, as a nation, we’ve decided that creative destruction is not allowed to occur for the Too Big to Fail banks.  And that alone is the primary reason why they need to be strictly regulation.

You can’t have it both ways.  If you’re not going to regulate them then you must allow the market to work and the process of creative destruction to play out.  That’s clearly not an option and so regulation is the preemptive common sense approach.  Unfortunately, the time for that appears to have passed.   And so the boom/bust cycle continues.   Since we have not regulated the banks properly it’s only logical that creative destruction will again impose its will on this sector at some point in the future.  Next time, I hope we will be wise to utilize that event to fix this serious flaw in our economy.

The paper is attached in its entirety here.



* This post was written in 2011 before Mr. Roche founded Monetary Realism, a post-MMT school that 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.

Some pundits are unhappy with the Oracle of Omaha’s proclamation that a debt crisis is not an issue for the USA. They reference the following comments from a few weeks ago and cite the comments as “silly talk”:

“The United States is not going to have a debt crisis as long as we keep issuing our debts in our own currency. The only thing we have to worry about is the printing press and inflation.”

And when someone starts claiming that Buffett is talking “silly” you should probably start wondering who is actually being silly because, as Buffett likes to say, “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”   I can assure you of two things – this MarketWatch article will take you less than half an hour to read and Warren Buffett is not the patsy in it.

The article uses all the same misconceptions that are common in the media today.  In some form, they argue that the USA, being just like a household, is fiscally constrained and must maintain its balance sheet in the exact same way that a household or business would.  Of course, this is totally illogical because the USA is a sovereign currency issuer with an endless supply of currency in a free floating exchange rate system.  Households, businesses, US states and EMU members are all constrained in their ability to spend because they are all currency users.  They must always collect revenues or amass debt before they can spend.  The USA works in the exact opposite way.  As a currency issuer, the US government can always procure funds so it has no solvency constraint.

Now, an interesting aside arose the other day during my conversation regarding Austrian economics (feel free to skip the next two paragraphs if you were not involved in the Austrian debate as it is a minor tangent).  A very astute commenter noted that the Fed could provide reserve balances with which the private sector can save.  In other words, the government need not deficit spend in order for the private sector to save.  That’s all well and good, however, it is not realistic.  We did not create a government so that the Federal Reserve could feed its various minions with reserve balances.  We created a government because we believed that this supra entity could provide some public purpose.

As highly social pack animals, it’s not surprising that we form large united groups that work to generate some public purpose.  In establishing these supra entities we establish ways in which the members of these societies can interact in attempts to achieve greater prosperity by leveraging the abilities and knowledge of the entire group.  In modern times, that has always involved a common currency and some level of public spending by the supra entity on these various public works.   Spending necessitates taxation.  And the tax system in a modern fiat government is the glue that binds.  But in order to tax this government must first name the thing that can be used for tax payments and it must actually create these notes.  So, while it’s technically correct that a government need not spend in order for the private sector to save, it is not realistic because reality shows that governments exist for specific reasons and they therefore spend for specific reasons.  Removing the government from the equation and concluding that the private sector can still save because of the Federal Reserve is not based in any sort of reality.

But I digress.  The article cited several “experts” on the history of debt.  Of course, the king defaultista, Niall Ferguson was trotted out to show how “silly” Buffett is:

[Buffett] “must know this is nonsense.” Ferguson continues, “Britain had complete monetary sovereignty in the mid-1970s and yet the IMF had to be called in. I could give numerous other examples. And then there is the inflation risk, which is implicit in his statement. We won’t have a debt crisis because we can print unlimited quantities of paper dollars. If that’s the good news, I don’t want to hear the bad.”

Now, it’s helpful to put things in perspective.  Ferguson has been predicting the demise of the US empire for well over a decade.  In a 2003 working paper he said the following:

“So what will happen? And when? The answers to both these questions depend on how quickly Americans wake up to fiscal reality. Perhaps the hardest thing to figure out is why they haven’t done so already. Even financially sophisticated Americans seem not to appreciate the fragility of the country’s fiscal position.”

He went on to discuss how the bond market would one day awake and yields would surge and catastrophe would strike:

“A widening gap between current revenues and expenditures is usually filled in two ways.  The first is by selling more bonds to the public. The second is by printing money.  Either response leads to a decline in bond prices and a rise in interest rates – the incentive people need to purchase bonds.”

There’s a reason why Ferguson writes books, teaches and doesn’t run a fixed income trading desk – he could have blown up several hedge funds betting against US government bonds since 2003.  And yes, it is important to point out these horrible calls because someone who has been wrong as long as Ferguson must reconsider their thesis or be shunned by the investing public.  Being right matters in this world.  Particularly when we are discussing matters that influence millions of people.  This is not a joke to me and should not be a joke to anyone else.  And frankly, we should all be sick and tired of people who trot out the same old tired arguments year after year and fool people into buying their new book.  We are talking about people’s lives so if you’re going to spend the better part of a decade being wrong you should do everyone a favor and either alter your thesis, stop pretending to be an expert in these matters or start writing books on different subjects.

But despite being wrong about the collapse of America and its inevitable bankruptcy for a decade now, Ferguson’s points are not entirely without merit.  As Britain proved, a monetarily sovereign government can choose to go bankrupt or accept aid from an outside entity.  The USA could choose to default on its debt tomorrow if it wanted to.  The game of chicken that is currently being played with the debt ceiling should make that clear.  But that’s a political choice and not an operational choice.  Only the USA can issue dollars and because our debt is entirely denominated in the currency that we have endless supply of it is operationally impossible for the USA to default on its debt in the same way that a household, state, business or EMU country can.  It is an irrefutable fact that the USA cannot run out of the dollars that only it can produce.

But as Buffett pointed out, the government can cause horrid inflation by spending in excess of productive capacity.  This clearly isn’t the case currently.  Core inflation is just 1.3% and the headline figure is just 3.1%.  And almost the entire spread over core is due to motor fuel prices.  To blame the USA’s below trend inflation (yes, below trend even with near record high gasoline prices) on spending policies is simply misleading.  In addition, the US money supply is not growing above trend (see here for proof) so all of the fear mongering about Fed “money printing” has turned out to be flat out wrong.

As for hyperinflation - I have studied the history of hyperinflations and written extensively on it. Hyperinflation is a uniquely psychological event that results in complete rejection of the sovereign currency.  It primarily occurs during a regime change.   Is hyperinflation a risk currently?  I would put the odds at slightly higher than 0%.  There is very little in the current environment in the USA that is consistent with past cases of hyperinflation.

Next up was “pre-eminent scholar of monetary policy”, Allan Meltzer who brought out another classic fear mongering point:

“We can have a crisis if the Chinese or Japanese start selling their mountains of dollar debt, or if the dollar collapses instead of declining, and if we get a big inflation.”

This is beyond misleading.  China accumulates dollars reserves because they choose to run a FX peg with the USA and a trade surplus.  By definition, their central bank accumulates dollar reserves because of this.  There are only a few things China can do with their dollar reserves.  They can let them sit in the equivalent of a checking account collecting dust.  Or they can buy USD denominated assets.   Now, they can try to buy Chevron again, but we all know how that ended up.  Instead, they choose to buy interest bearing paper in the form of US Treasuries.  The USA doesn’t need China to buy treasuries.  Their purchases don’t “fund” anything.  We don’t call China before we sell bonds and make sure that they are there to buy.  China gets pieces of paper with old dead white men on them in exchange for real goods and services.  If they choose to stop accumulating these pieces or paper then they need to dramatically alter their domestic economic policy.  Ironically, most of the people who argue that China is manipulating their currency are the same people saying that we need China to buy our bonds….And as for China selling?  Well, who are they going to sell to?  And why would they do anything that might be to the detriment of the trade partner that they willingly choose to rely on for much of their economic growth?  As you cans see, the fear mongering doesn’t add up when you think about it all rationally.

Next up is Desmond Lachman of the conservative American Enterprise Institute who cites the good old bond vigilantes:

“If the markets think that the U.S. public debt situation is out of control,” he says, “and that the Fed is going to print money to inflate the U.S. out of its debt problems, blood will be spilt in the bond market as people dump Treasuries until interest rates rise very high to compensate them for the inflation risk. That will be disastrous for the stock market and for the U.S. economy.”

Ah yes, those beloved (and very sleepy) bond vigilantes.   For some perspective on how dreaded these vigilantes are we should reference the recent history of long bond yields:

Long bond yields are a function of Fed policy and inflation.  As previously mentioned, core inflation is hardly a concern and the Fed remains at 0%.  I won’t bore readers with the mechanics of the bond market, but let’s just all agree that, at 3.1%, these vigilantes sure are bad at their job.  Actually, they’re quite good because they’ve correctly predicted that high inflation and government default are low probability events currently.

Senator Alan Simpson, who co-chaired the bipartisan debt commission is later quoted in the piece saying:

“It won’t be the old slippery slope crap that we read about,” he said. “It’ll be very swift and very dramatic, like in Greece or Ireland or Portugal or Spain or wherever. I don’t know where this is going, but I tell you, it won’t take long.”

It’s amazing that this man was running the debt commission.  He doesn’t even understand the difference between the EMU and the USA.  The EMU nations are the functional equivalents of the US states – they are currency users! Yes, they are revenue constrained and yes, they are susceptible to debt crisis.  But comparing the USA to the nation of Greece is entirely illogical and misleading.  Just because they are both countries doesn’t mean they are equivalent in terms of their monetary systems. This sort of mistake speaks magnitudes about the state of our current leadership.  The people in the very highest offices are making the simplest of mistakes when it comes to understanding our monetary system.  It’s no wonder the country is such an economic mess currently….Unfortunately, most of this stuff is such high finance that we could never expect the average citizen to understand it to any extent that they would actually get upset and demand change.  So people like Alan Simpson continue to influence policy.

Next up is Laurence Kotlikoff of Boston University (who co-authored the inaccurate working paper from above with Niall Ferguson).  He says:

“On the face of it,” he says, “his statement is true right up to the point that it’s not. That is to say, we have some capacity to borrow, but it is not unlimited and the market will shortly make that clear, in my opinion.”

He wrote the same exact thing in 2003.  Again, there’s a reason why Kotlikoff isn’t running a fixed income trading desk.  Kotlikoff clearly believes that the bond market funds our spending.  And he clearly doesn’t understand the mechanics of the bond market.  If he had understood this in 2003 he would have never written such comments.  Since he’s writing it today it’s clear that he still doesn’t understand.

The article concludes by demanding that Warren Buffett elaborate on his comments and explain why he is not wrong:

“With the debt stakes so high, Warren Buffett owes it to his legion of admirers and the public at large to explain more fully what he means in saying categorically, “the U.S. is not going to have a debt crisis.”

Warren Buffett doesn’t owe anyone anything.  What the American public owes to itself is to learn how our monetary system actually works.  And these academics and policymakers that are cited in the MarketWatch piece owe it to the American public to learn how the system actually works.  There is one thing that is helping to destroy this great nation and that is the persistent fear mongering that is constantly peddled by people who are pushing a political agenda based on false perceptions of the US monetary system.  This environment of perpetual fear is helping to scare the greatest entrepreneurs in the world from doing what they do best.  In the meantime, the rest of the world is eating our lunch.

All of this fear mongering is misguided, but helping to do one thing well – cause the currency users to fear the economy they exist within.  And therein lies the most interesting component of this entire debate.  These misguided fears could be the very thing that threaten this country the most.  It’s time for Americans to stop being scared by old rich white men selling books and newsletters.  And if we had a leader who understood all of this he/she would stand up in public and tell the American citizenry that they have nothing to fear but fear itself.  Unfortunately, that leader doesn’t exist.


In his Financial Instability Hypothesis, Hyman Minsky described how a process of Ponzi finance can result in increased financial instability:

“over a protracted period of good times, capitalist economies tend to move from a financial structuredominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance. Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently,units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.”

The recent downturn in commodities is interesting for several reasons. None more so than the fact that investors are now beginning to notice that the price increases have been driven in large part by speculation generated by QE2. Regular readers are well aware of this fact, however, much of the investment world has been basing their commodity thesis on booming global economies, myths of money printing, misguided fears of hyperinflation and not the primary driver – financialization.

As the Bank Of Japan recently pointed out, there has been a substantial speculative premium in many commodities. In many ways this is reminiscent of 2008 when the Fed was seen as creating inflation, however, what lurked beneath the surface was disastrous deflation. While this environment isn’t nearly as susceptible to collapse, we are still at risk of a major dislocation due to the Fed’s severely misguided policy of QE2 and the market’s dramatic misinterpretation of it.

Financialization of markets

FT Alphaville has done a fantastic job in recent weeks and months covering some of the dislocations and connecting the dots. In a recent story they cited the continuing use of copper as a financial tool:

Veteran copper market watcher Simon Hunt of Simon Hunt Strategic Services believes the dynamics are the result of a longstanding misunderstanding by the industry of the difference demand and consumption. Consumption, being the actual indicator of real demand.

As he noted in a research report earlier this week:

In other words, copper price movements have been quite unrelated to actual business. Demand, in most analysts’ calculations, is confused with consumption. It is the aspect of demand that is material acquired by financial institutions, which has been the principal driver of price. Last week‟s correction was part of the game being played out. At between $9000 and $10,000 there was difficulty in finding new investment buyers; lower prices are needed for the game to continue.

And if that is true, there could be yet another — potentially more sizeable — correction yet.

This is just one obvious effect of this sort of mass financialization of our economies. Other obvious examples include the Chinese farmers who are hoarding cotton due to Fed money printing fears. Other examples, such as the continuing surge in oil prices despite tepid fundamentals, are less obvious. And every once in a while, we can see the financialization impact with our own two eyes as we were able to just a few weeks ago when the Fed announced their continued easy policy stance and every commodity went racing higher in a speculative frenzy in a matter of minutes.

Why is this problematic?

The risk the Fed creates, when they intervene in markets in this manner, is that they generate the risk of a major dislocation in the markets that feeds over into the real economy. When you create an implicit guarantee and speculators take you at your word they are more likely to generate a destabilizing pricing environment. This was recently seen in silver prices where the inflation bandwagon has run full speed off the tracks and now real silver producers are being forced to deal in a market that is entirely unstable and unpredictable.

When the Fed intervened via QE2 they were not really altering the economy in any meaningful way. This asset swap did not change net financial assets. It did not create more money. It did not result in any stimulus. All it really did was bolster asset prices via the psychological routes. In essence, the Fed was trying to create nominal wealth with the hope that this would translate into real wealth. This can all be proven now by looking at lending data, falling GDP, the stagnant money supply, and exploding margin debt at the NYSE. So, the Fed goes into the market and tells everyone to buy risk assets. Don’t fight the Fed, right? And they didn’t. But focusing on nominal wealth creates the risk that the cart will come before the horse, ie, prices will substantially outpace fundamentals and create a destabilizing market environment.

How does this play out?

We can visualize this economic journey by envisioning a car on a moderately hilly road. This is comparable to the natural course of the business cycle. There will be ebbs and flows, ups and downs. Markets are irrational as they are. But if a powerful entity is able to intervene in this course of events it’s not unreasonable to expect that the cycle could experience increased volatility as its forces take an unnatural form by distorting the underlying economic reality. In an attempt to generate stability the entity could theoretically create increasing instability. In the case of the Federal Reserve and QE2 this involves focusing on nominal prices as opposed to policy implementation that benefits the real economy. By creating a price increase in nominal terms we risk exaggeration in the pricing mechanism. As we experienced in 2008 that can be devastating as prices surge and then collapse and fear captures the real economy in the aftermath. The following figure shows how such environments might be altered over time to experience increased volatility and business cycle disruption:

What has occurred in recent months is exactly what Dr. Bernanke desired. If we change the perspective on our car on the road we can better visualize how this environment plays out. As our car picks up speed it continues down the road with increasing velocity. Slowly, but surely the participants decide the car can handle more participants and increased velocity that will generate increased pleasure (market gains due to increased speculative behavior). Eventually, the car enters a tight turn (or a bump in the economy). If the speed is greater than that of the natural forces exerted against the car (price disequilibrium resulting in severe instability) then the car will leave the road and enter a period of instability as it veers into uncommon grounds.

This is exactly what occurs when markets enter a period of disequilibrium. In my piece on the silver bubble a few weeks ago I described the four primary components of this disequilibrium:

  • Strong fundamental underpinnings. Bubbles do not merely appear out of nowhere. Bubbles grow over a period of time based on strong fundamental underpinnings. There is always a very good economic reasoning behind bubbles. This feeds into the rationalization of its existence and justifies a “it’s different this time” mentality that later occurs.
  • Ponzi builds. A naturally occurring ponzi process begins. As a recency bias builds (the tendency to overweight recent events and ignore historical facts) the system begins to exhibit herding behavior as more and more investors get in on “the only game in town”. This becomes amplified by the media, those with a vested interest in this particular market, those who “throw in the towel” after wrongly betting against the trend, etc.
  • Illusion of stability within disequilibrium. The illusion of control increases as investors become increasingly confident in the market. They increase their bets, increase price targets, etc. Investors begin to convince themselves that it is “different this time”. All of this is occurring as the system grows increasingly unstable. I like to think of it like a spinning top. When you initially throw a top into a tight spin there is a distinct order in its movements. They are predictable and stable. But as the top loses momentum it begins to spin uncontrollably. The system becomes unstable, unpredictable and ultimately breaks down. Bubbles work within the same sort of illusion. What appears like a stable and self sustaining system is in fact increasingly unstable and entering an inevitable disequilibrium that breaks down.
  • Systemic collapse. All bubbles collapse. It is never “different this time”. As this prior herding effect begins to breakdown there is a flood for the exits as the herd reverses its controlled march into a panicked stampede. The gig is up. Collapse ensues.

In the case of our car, it involves a moderate velocity which is slowly increased as the riders become increasingly confident in the car’s performance and increased pleasure being generated from the ride. As the car enters its first portion of the turn (or bump in the economy) it is tested, but maintains stability. This stability actually increases the instability as the ponzi builds and the riders become even more confident in the car’s performance. In the case of the Fed, the riders need only a small vote of confidence to put the pedal to the metal. This leads to stage three in the disequilibrium where everyone now believes it is different this time. There is no chance the car can slide off the road or threaten its riders. And of course, that exact event occurs and the system is thrown into chaos.

In asset markets like silver the car gained so much momentum that it actually created a destabilizing force. In the ensuing collapse we run the risk that the real economy is impacted through the fear and uncertainty that is involved in the ensuing market collapse. The collapse in silver prices could materially impact the way real producers and consumers utilize the metal. And that collapse can be directly attributed to the various destabilizing forces that helped it to build the momentum that led to the surge in prices and ultimately a period of instability.

This is the risk the Fed has created multiple times over the course of the last 20 years and it is the same risk I believe they have created today. Will it result in a full blown commodity collapse and a highly destabilized global economic event? I don’t know and neither does anyone else. But as a risk manager I have to accept the fact that the risk now appears elevated. But perhaps more importantly, the Central Bank of the United States should recognize the destabilizing nature of its misguided policies. In the future, it would be my hope that the Fed focus more on the real economy and a bit less on nominal prices. Putting the cart before the horse can be highly destabilizing and can result in increased systemic instability. As we sit with 9% unemployment well into an economic “recovery” we should all be aware of how damaging that instability can be….


If you’ve been looking for an honest assessment of the recent commodity rally look no further than this bit of research by the BOJ.  They provide a broad overview of the factors that are currently impacting commodity prices and conclude with a practical and fact based argument – global central banks, the financialization of commodity markets and supply/demand mechanics are all working in tandem to cause a perfect storm in commodity prices. They write:

“While the strong increase in commodity prices has been driven by global economic growth propelled by emerging economies, speculative investment flows into commodity markets have amplified the intensity of the price surge. The dynamics of global commodity prices has been changing as well, in accordance with the growing presence of financial investors in commodity markets. The entry of new financial investors has paved the way for the “financialization of commodities”. Consequently, global commodity markets have become more sensitive to portfolio rebalancing by financial investors, which has made commodity markets more correlated with other asset markets, including major equity markets. Furthermore, globally accommodative monetary conditions have played an important role in the surge in commodity prices, both by stimulating physical demand for commodities and driving more investment flows into financialized commodity markets.”

Unlike the SF Fed, which just yesterday absolved the Fed of any impact on commodity prices (in fact said QE2 was exerting downward pressure on commodity prices), the BOJ performs multidimensional & unbiased research that finds the Fed and global central banks are having a dramatic impact on commodity prices.  Of course, they’re not entirely to blame, but these unbiased findings put a very serious hole in the persistent Fed talk that attempts to distance them from the commodity price increases.  In my opinion, this is the most precise and accurate conclusion I have seen with regards to this subject.


Source: BOJ



“Inflation is always and everywhere a monetary phenomenon.” – Milton Friedman

Hyperinflation is poorly understood. As its name might imply, most people believe hyperinflation is merely inflation on steroids. But that’s not necessarily accurate. Inflation can and does occur in a perfectly healthy economy. In fact, since 1913 when the Fed was founded inflation in the USA has consistently risen at 3.5% per year on average. One might assume that this means the country has experienced some great injustice, but the truth is that the 1900′s were characterized by the greatest economic expansion and wealth creation the world has ever seen. Despite the common citation that “the $USD has lost 90% of its value” Americans experienced an unprecedented period of prosperity during this inflation. In fact, the prosperity became so gross in the 1990′s that Americans felt entitled to second homes, second cars, and just about every other luxury good known to man. What has not occurred is hyperinflation, which is a very different animal than inflation. Hyperinflation is a disorderly economic progression that leads to complete psychological rejection of the sovereign currency.

Contrary to popular opinion, excessively high deficit spending and exorbitant government debt levels are not the actual cause of a hyperinflation. In most cases they have been the result of other exogenous events such as ceding of monetary sovereignty, war, rampant corruption or regime change. It is these exogenous events that result in the public’s rejection of the currency, a collapse in the tax system and the government response of printing more money to fill in the confidence void. Ultimately the confidence void cannot be filled and the currency is fully rejected by the public in the form of hyperinflation.

In my treatise on the monetary system I discuss the importance of this unspoken agreement between the private sector and public sector:

“What backs these notes we created? What gives them value? Ultimately, these notes represent some amount of output and productivity. The notes in and of themselves have no intrinsic value, but serve as a medium of exchange that allows the citizenry to exchange various goods and services. The willingness of the consumers in the economy to use these notes is entirely dependent on the underlying value of the output and/or productivity and my ability to enforce its usage. The government cannot force its value on its citizens. The value of these notes is ultimately determined by the goods and services that are produced by the citizens and the value that other citizens are willing to pay for these goods and services. Therefore, government has an incentive to promote productive output. Otherwise, they risk devaluing the currency. Paying its citizens to sit at home doing nothing, buy cars they don’t need or purchase homes they can’t afford are unproductive forms of spending (sound familiar?). If government is corrupt in its spending and becomes an institution that is mismanaged and detracts from the private sector’s potential prosperity then it is only right that the citizens revolt, denounce the sovereign currency and demand change.

The United States Secret Service was in fact created specifically for this purpose – to protect the US Dollar. There is arguably, nothing more important to government stability than maintaining the value and faith in the sovereign currency. As long as an economy is productive, the sovereign nation can enforce the use of said currency, and as long as we don’t issue excessive currency there should always be demand for it. In other words, trust in the national currency is safe as long as the rule of law is maintained, corporations are productive and I maintain my ability to tax you. If my government becomes corrupt, spends well in excess of productive capacity or mismanages the economy then there is an increasing chance of currency collapse (hyperinflation). In essence, this occurs when the citizenry lose faith in the sovereign currency and slowly refuse to transact and produce in that currency.”

The users of the currency can always reject that currency. And I believe they should reject the currency if it is not being utilized in a manner that furthers private sector prosperity. This rejection occurs in the form of a collapse in the tax system. When the sovereign loses the ability to tax the game is up. This occurred in Russia in the 90′s, in several Euro nations in the 1920′s (no, Weimar was not the only country that suffered hyperinflation) and most notably in Zimbabwe in recent years.

A Historical Review

A quick review of the modern economic cases of hyperinflation show striking similarities. Most notably, they involved war (the losing end of a war), regime change or foreign denominated debt. All resulted in catastrophic hyperinflations.

(Figure 1)

But it’s important to note the cause and effect here. These hyperinflations were not merely monetary events. It was not just “high inflation” or excessive government spending. It was a full blown rejection of the sovereign currency. This is a dramatically different set of circumstances than a gradual increase in inflation or a consistent inflation. The citizens rejected the currency due to these exogenous events.

But why does the hyperinflation occur? As I mentioned above it generally occurs due to extreme exogenous events. Hyperinflations have generally occurred in nations with rampant corruption, war, productive collapse, or other extreme exogenous factors. The “money printing” that generally results is not actually the cause of the hyperinflation. It is merely the result of this exogenous event.

The Case of Weimar

The Weimar Republic is the most notable hyperinflation. But it was not the only case of hyperinflation that occurred in Europe at the time. In fact, several European nations were ravaged by the war, war reparations and regime changes that ensued. In the case of Weimar the country was already in a fragile state after Germany lost WWI. To add insult to this injury the allied nations demanded punitive war reparations resulting in foreign denominated debt. Mises elaborated on the insurmountable pressures this caused for Germany:

“The German government has no alternative way of covering its reparations obligations. It would have no success if it tried to raise the sums demanded by issuing bonds or raising taxes. Given the way matters currently stand with the German people, a policy of compliance could not count on the stand with the German people, a policy of compliance could not count on the consent of the majority if its economic consequences were clearly understood and they were not deceived as to its costs. Public opinion would turn with elemental force against any government that were to try to fulfill the obligations undertaken toward the Allied Powers completely.” (Mises 1923, p. 31)

In his excellent book, “When Money Dies” Adam Fergusson described how hyperinflation is more a psychological event than a purely monetary event:

“To ascribe the despair entirely to inflation would be misleading. Undoubtedly, though, inflation aggravated every evil, ruined every chance of national revival or individual success, and produced the conditions in which extremists could raise the mob against the state. It undermined national resolution when simple want might have bolstered it.

Money is no more than a medium of exchange. Only when it has a value acknowledged by more than one person can it be used. Once no one acknowledged it, the Germans learnt, their paper had no value. The discovery that shattered their society was that the traditional repository of purchasing power had disappeared and that there was no means left of measuring the worth of anything.

When life is secure, society acknowledges the value of luxuries, those enjoyments without which life can proceed but which make it much pleasanter. When life is insecure, values change. Without warmth, a roof, or adequate clothes, it may be difficult to sustain life for more than a few weeks. Without food, life can be shorter still. At the top of the scale, the most valuable commodities are water and air. For the destitute in Germany, whose money had no exchange value, existence came very near these metaphysical conceptions. It had been so in the war. In All Quiet on the Western Front, Müller died ‘and bequeathed me his boots—the same that he once inherited from Kemmerick. I wear them, for they fit me quite well. After me, Tjaden will get them: I have promised them to him.’”

In the above quote from “When Money Dies”, Fergusson was describing the depression that arose in the Weimar Republic in the 1920′s when they suffered their hyperinflation. The Weimar Republic was a war torn region with a government in turmoil. Economic upheaval compounded the problems as the war reparations from the Treaty of Versailles and the foreign occupation of the Ruhr placed severe strains on the Republic’s ability to prudently manage their domestic economy/finances. All of this combined to create a scenario that was highly unusual and combustible. German Financier Carl Melchior nicely summed up the situation in Germany in 1921:

“We can get through the first two or three years with the aid of foreign loans. By the end of that time foreign nations will have realized that these large payments can only be made by huge German exports and these exports will ruin the trade in England and America so that creditors themselves will come to us to request modification.”

Melchior was ultimately proven correct as the global economy collapsed in spectacular fashion in the late 20′s. But the hyperinflation was well underway when Melchior spoke these famous words and it was not solely due to the government printing presses, but rather a complex (and unusual) series of events that reduced private sector aggregate demand, shattered the public’s faith, led to extreme government intervention in currency markets and ultimately resulted in the failure in the national currency.

Severe (and unusual) exogenous circumstances lay the groundwork for the hyperinflation to begin, these severe (and unusual) exogenous circumstances initiate the cycle, severe government ineptitude furthers the hyperinflation, severe public mistrust exacerbates it and government ultimately completes the cycle when they desperately crank the presses in an attempt to flood the market with an unwanted currency. What’s important to note here is that the printing press exacerbates and ends the cycle rather than actually initiate it. What lays the groundwork for the hyperinflation is severe exogenous forces or a highly unusual environment that government responds to ineffectively or inappropriately.

So Weimar Republic was not merely a case of “money printing” gone wild. In fact, it was the regime change, fragile state of mind, foreign denominated debts and productive collapse that resulted in the excessive “money printing”, collapse in the tax system and hyperinflation.

The Case of Zimbabwe

The other often cited case of hyperinflation is Zimbabwe. This is another extraordinary circumstance. To call these events “rare” and “severe” is a vast understatement. Zimbabwe is an utter economic catastrophe. GDP has declined 40% since 2000, unemployment has risen as high as 95% and hyperininflation has ravaged the country. The issue is far more complex than I have the time or space to deal with here, but in essence, Zimbabwe has proven a highly inefficient and corrupt nation for several decades. This was another case of fragile emotional state due to rampant government corruption, regime change, productive collapse, foreign denominated debts and an eventual collapse in the tax system. The Mugabe government is one of the most controversial in the world and has proven to be financially incompetent. A former government minister of Rhodesia, Denis Walker nicely summed up the environment in Zimbabwe in 1989:

“Zimbabwe’s government, already morally bankrupt, will decline towards economic collapse.”

Like Melchior before him, he was proven correct. But unlike Germany’s war torn economy the Zimbabwean economy is a sad story of centuries of racist regimes followed by incompetent leadership. The situation in Zimbabwe has largely arisen from the controversial land reallocations which sliced up their largest export and domestic form of productivity into the hands of the agriculturally incompetent. As internal production of food collapsed the government was forced to rely on the kindness of strangers. The Grecian “beggar thy neighbor” policy began as Zimbabwe started to rely on foreign imports of food. Unemployment increased, civil unrest increased and the government lost control of its internal finances and the currency ultimately collapsed as the citizenry voted “no confidence” in the government currency. Allow me to repeat what I said above:

“Severe (and unusual) exogenous circumstances lay the groundwork for the hyperinflation to begin, severe (and unusual) exogenous circumstances initiate the cycle, severe government ineptitude furthers the hyperinflation, severe public mistrust exacerbates it and government ultimately completes the cycle when they desperately crank the presses in an attempt to flood the market with an unwanted currency. What’s important to note here is that the printing press exacerbates and ends the cycle rather than actually initiate it. What lays the groundwork for the hyperinflation is severe exogenous forces or a highly unusual environment that government responds to ineffectively or inappropriately.”

The Cause & Effect

What is consistent among cases of hyperinflation is a number of rare exogenous circumstances:

  • A ceding of monetary sovereignty (usually in the form of foreign denominated debt, a currency peg, etc).
  • Extraordinarily unusual social circumstances (loss of war, regime change, etc.).
  • Very low levels of faith in government during regime change (high public mistrust).
  • Rampant corruption.
  • A collapse in the domestic economy.
  • A breakdown in the tax system.

The most notable environments involving hyperinflations are war, regime change, government corruption and a ceding of monetary sovereignty.

Wars are particularly disruptive for a society for obvious reasons. Being on the losing end of a war is not only disruptive, but catastrophic. It’s not surprising that hyperinflations tend to occur in war torn nations because the tax system tends to fail when the citizens begin to question whether or not their government will exist in the coming years. Civil wars have tended to result in hyperinflation as the tax system collapses and the currency issuer continues to spend to finance their losing cause. The American civil war and the Confederacy is exhibit A.

Regime changes are equally disruptive. While they can be highly beneficial in the long-run regime changes have tended to coincide with hyperinflations due to the fact that a new government is greeted with skepticism. The uncertainty in such an environment is extraordinary. This was most notable following WWI when several regime changes in Europe ultimately led to hyperinflations.

Rampant government corruption is a highly destructive environment. A currency is based on an agreement between the public and private sector. If one party of this agreement is seen as corrupt the other party is likely to want out of the agreement. Zimbabwe is the modern day poster child of corruption and mismanagement of a domestic economy.

A ceding of monetary sovereignty is another primary culprit in hyperinflations. This is generally due to government incompetence (such as the current Euro arrangement), productive collapse or corruption. Notable cases include Argentina, Zimbabwe and the Weimar Republic. A ceding of monetary sovereignty via a pegged currency or accumulation of foreign denominated debt is a sure sign that a government is increasingly unstable and at risk of currency collapse.

Is Hyperinflation Coming to the USA?

While some of these ingredients exist in the modern day United States (to a very minor degree) I would argue that we are a long long way from experiencing the type of environment and downfall that is consistent with past hyperinflations. The most important aspects of currency collapse simply do not exist in the United States today:

  • We do not rely on the kindness of strangers (no foreign denominated debt).
  • We are not experiencing any sort of extraordinarily unusual social circumstances or severe exogenous forces (losing war, regime change, government corruption, etc).
  • We are not lacking confidence in the sovereign nation. If there is one thing that Americans are known for it is their resilience and borderline arrogance with regards to the strength of their country.
  • We are not experiencing a collapse in the domestic economy (not yet at least).

In sum, if you’re betting on hyperinflation in the USA I believe you’re effectively betting on the existence of a highly unusual and severe circumstance that happens to coincide with dependence on foreign denominated debt (of which there is none), an economic collapse in the United States (not happening yet), a dramatic decline in Americans’ confidence and ultimately the destruction of the world’s reserve currency. I do not believe that the current environment is consistent with the disorderly economic environments that are generally consistent with hyperinflations. Don’t get me wrong – we have big problems in the USA, but I think they are more manageable than many presume. Could the US government become corrupt and incompetent to the point of resulting in a rejection of the sovereign’s currency? Sure, but I don’t think that’s a very realistic outcome given the current environment. Thus far, markets have tended to agree with this as USA CDS remain among the lowest in the world and bond yields remain near their all-time lows.


In sum, hyperinflation is not merely high inflation. Hyperinflation is a disorderly economic progression that leads to complete psychological rejection of the sovereign currency. While government debts and deficit spending can exacerbate a hyperinflation they have not generally been the cause of hyperinflation, but rather the result of exogenous events. The excessive and incompetent monetary response is generally the result of severe exogenous forces at work such as war, regime change, corruption, or a ceding of monetary sovereignty.


The economic recovery is becoming broadly accepted and potentially priced into the markets.  The recent string of upside surprises in earnings reports and economic data show that the investment community has largely unappreciated the strength of the recovery.  But as the analyst community raises the bar the expectations for continued growth will become increasingly difficult to overcome.

While the days of 60+ ISM readings, record margins, and persistent earnings beats seem to have become the norm, the truth is that many of these indicators are highly cyclical by nature and/or mean reverting.  It’s not unusual for the investment cycle to peak at a time when expectations are high and this cyclicality begins to bite.

Recent data shows a few signs of at least a near-term blow-off in expectations.  This doesn’t mean the bull market is necessarily over, but it does present a sizable challenge for markets going forward.  Remember, market direction is not just the sum of the opinions of its participants.  Market direction is the sum of those opinions when compared to expectations.  The market does not care whether you think the FOMC will raise rates today.  You could very well end up being right and the market could still move against you as the opinions of the other participants are already priced into shares and broadly expected in advance.

There are several indicators that compare reality to expectations and give a real-time perception of this phenomenon.  I highlighted the Citi Economic Surprise Index last month.  This index shows the weighted historical standard deviations of data surprises comprised by the analyst community compared to the Bloomberg median estimates.  It has been flashing a warning sign for several weeks now and although it has come off its highs the index remains at a historically elevated level.

A few weeks ago Barry Ritholtz highlighted a similar phenomenon noted by SocGen analysts:

“After undergoing a massive rally since last September, risky assets are now technically vulnerable: SG Quant sentiment indicator is close to an all-time high, economic revisions have rarely such a high percentage of upgrades, equity volatility is at a four-year low, the Canadian dollar is dear versus the USD and lastly inflows into equities reached $8bn last month, led by “panic-buying.””

My Expectation Ratio, which measures the strength of future earnings growth compared to analyst expectations turned negative (sub 1.0) on February 28th.  This is the first time the index has turned negative since March 12th of 2010.  This is generally consistent with an environment in which strong earnings and robust corporate balance sheets are broadly expected and priced into shares.  While the current reading of 0.97 is by no means an extreme negative it could prove to be a risk in the current earnings season if we see further deterioration.  Over the course of the majority of the rally from the 666 lows the ER has remained firmly in positive (1+) territory except for a brief period preceding the flash crash.  A sustained downtrend in the index would likely precede a far more challenging earnings environment.

None of this points to impending doom and gloom in the markets, but as expectations rise in the near-term these indicators create barriers that the market could have difficulty overcoming.  The recent oil scare and the crisis in Japan could be enough to temper sentiment and bring expectations back down to earth.  That process, however, could take some time and involve continued downside risk in equities as these high expectations are cleared and fear breeds opportunity for upside.


There are, in my opinion, few things that threaten the sustainability of economic growth more than market disequilibrium. As I’ve discussed in recent months it is not mere coincidence that the Fed’s increasing involvement in the economy has coincided with the increase in market bubbles in recent decades.  The Fed has helped exacerbate the financialization of the US economy and this has helped directly contribute to our current predicament.  The result has been an appearance of stability inside an increasingly unstable system that is characterized by high valuations, more frequent recessions, deeper recessions and a growing discrepancy in the quality of life across the country.

This evolution has been fairly simple in my opinion.   The highly flawed economic theory of the 60′s & 70′s led policymakers to believe that markets were self regulating systems that could be largely controlled so long as the money supply was managed adequately.  These flawed theories resulted in mass de-regulation, placed a specific emphasis on monetary policy and gave the Fed an increasingly important role in markets.  Because the Fed can only intervene in markets via the banking system it was only natural that the Fed’s increased role in markets resulted in an increasingly important role by the banks themselves.  This resulted in what is now an obvious financialization of the US economy.  The effect of this financialization has become apparent in recent years as the banking system nearly brought the entire system to its knees in 2008.  But this financialization is far from over.  Since no reforms were implemented following the recent crisis (and the Fed and banks grew MORE powerful) it’s not incorrect to assume that this cycle of booms, busts and bubbles is not over. And we’re already seeing signs that the problems are only growing again.

As I’ve discussed in recent months the latest victim of the Fed’s intervention appears to be the commodity markets.  And I’m not the only one who has noticed this disequilibrium.  In his latest missive John Hussman discusses the recent rise of the bubbly commodity market:

“On that note, it’s clear to me that we’re seeing classic bubbles in a variety of commodities. It is very unlikely that this is due to global demand growth. Even with an exhaustible resource, it is a well-known economic result (Hotelling’s rule) that the optimal extraction rule is one where the price rises at a rate not much different from the interest rate. What we’ve seen lately is commodity hoarding, predictably resulting from negative real interest rates provoked by the Fed’s policy of quantitative easing.”

“Fortunately for the world’s poor, the speculative dynamic that has created a massive surge in commodity prices appears very close to running its course, as we see very similar “microdynamics” in agricultural commodities as we saw with oil in 2008. That’s not to say that we have a good idea of precisely how high prices will move over the short term. The blowoff phase of a bubble tends to be steep, but so short-lived that it affords little opportunity to exit. As prices advance in an uncorrected parabola, the one-sided nature of the speculation typically gives way to a frantic effort of speculators to exit simultaneously. Crashes are always a reflection of illiquidity in two-sided trading – the inability of sellers to find eager buyers at nearby prices.”

There’s no telling when a bubble ends and it’s impossible to quantify its impact.  Oliver Wyman Group thinks this commodity bubble could be far from its climax, but they are clear about its impact:

“Western central banks pumping cheap money into the financial system was seen by many as having the dual purposes of kick-starting Western economies and pressing China to appreciate its currency. Strict capital controls initially enabled the Chinese authorities to resist pressure on their currency. Yet the dramatic rises in commodities prices resulting from loose Western monetary policies eventually caused rampant inflation in China. China was forced to raise interest rates and appreciate its currency to bring inflation under control. The Western central banks had been granted their wish of an appreciating Chinese currency but with the unwanted side effect of a slowing Chinese economy and the reduction in global demand that came with it.Once the Chinese economy began to slow, investors quickly realized that the demand for commodities was unsustainable. Combined with the massive oversupply that had built up during the boom, this led to a collapse of commodities prices. Having borrowed to finance expensive development projects, the commodities-rich countries in Latin America and Africa and some of the world’s leading mining companies were suddenly the focus of a new debt crisis. In the same way that the sub-prime crisis led to a plethora of half-completed real estate development projects in the US, Ireland and Spain, the commodities crisis of 2013 left many expensive commodity exploration projects unfinished.

Western banks and insurers did not escape the consequences of the commodities crisis. Some, such as the Spanish banks, had built up direct exposure by financing Latin American development projects. Others, such as US insurers, had amassed indirect exposures through investments in infrastructure funds and bank debt. Inflation pressure in the US and UK during the commodities boom had forced the Bank of England and Fed to push through a series of interest rate hikes that forced many Western debtors that had been holding on since the subprime crisis, to finally to default on their debts. With growth in both developed and emerging markets suppressed, the world once again fell into recession.”

I am not so certain that the end of this bubble is far off.   As I said above, booms and busts appear to be becoming more frequent. In “The Bernanke Put and the Fed’s Trilemma” I discussed how the current environment is not dissimilar to a very obese man who suffers a series of heart attacks, but because he never resolves his inherent problems, his health problems only continue to deteriorate:

“What I fear most about the current cycle is that we have not allowed the markets to sufficiently clear.  If that is the case you can think of the global economy like an obese man who fights to lose weight in an effort to fend off what is an almost certain heart attack.  After a multi decade binge he suffers a massive heart attack (think LTCM circa 1998).  The doctors save him by intervening, but they don’t actually help the man fix his inherent problems (dying internal organs and lack of discipline).  In the case of the economy this is global imbalances, structural flaws in the banking system and a lack of regulation.  The man vows to lose 50% of his total body weight, but after losing 20% of his total body weight he decides the process is too grueling and is taking too long.  A fast food restaurant opens up next door (hello government bailouts!).  He once again feels the need to stimulate his lust for food.  So, he binges again (think Greenspan 2001).  A new boom occurs before he ever becomes fully healthy.  Over the ensuing 7 years his body weight doubles.  He’s now 60% heavier than he was in 1998!  Of course, this is unsustainable.  His body begins to breakdown.  Before you know it he is suffering a total system failure (think Lehman brothers).  But again, thanks to modern medicine (or incessant Fed intervention) the man is once again saved.  Over the following year he loses 25% of his body weight.  It’s an arduous process and certainly not enjoyable, but it must be done.  The good news is he’s 25% lighter.  The bad news is he’s 20% heavier than he was in 1998 when he had his first setback.  Nothing has changed inherently.  He has the same failing internal organs and the same failing disciplines.   But his next binge begins from a weaker starting point and a more dangerous level. You can imagine how this story ends.”

We are indeed the obese man who simply refuses to accept that he has a very real problem that requires dramatic lifestyle changes.  It’s clear that policymakers have no interest in accepting the facts.  But as investors we can calculate the risks and attempt to sidestep the Fed’s landmines.  Forewarned is forearmed.  As Mr. Hussman says, “The blowoff phase of a bubble tends to be steep, but so short-lived that it affords little opportunity to exit.”   With the exception of gold (which will serve as a fear hedge), commodity prices look increasingly unstable….


As always, this month’s Absolute Return Letter from Niels Jensen is a must read:

“Many commentators, especially those punters eager to express extreme views of more or less dubious quality on the internet, have been only too willing to declare the recent increase in commodity prices a function of the ‘money printing’ policy applied by central banks in the western hemisphere following the credit crisis of 2008-09. The fact is that the Fed and other central banks can ’print’ trillions of dollars, euros or pounds without it having  any effect whatsoever on present or future inflation. What really matters is what the commercial banks, whose balance sheets are boosted by the QE, do with the money, and the overwhelming evidence is that overall lending activity has moderated quite dramatically since the credit crisis (see chart 2). Hence the notion that QE is to blame for the current spike in inflation is pure and simple nonsense.”


The Fed’s purchases of treasuries continue to attract a huge amount of attention.  Despite solid evidence that the program is failing to have any real fundamental economic impact there are other worries about the program.  None has been more apparent in recent weeks than the Fed’s supposed monetization of the US government’s debt.  These fears of monetization are unfounded due to the various myths that are perpetually touted by the mainstream media, supposed experts on the US monetary system and even Fed officials.

In an article Monday, Bloomberg reported that the Fed has been buying an exorbitant proportion of the recently issued treasury debt:

“More than 40 percent of the government bonds the Fed bought in January for its so-called quantitative easing were auctioned in the previous 90 days, up from 20 percent in December and 15 percent in November, according to Bank of America Merrill Lynch. The central bank is concentrating on newer securities as its $600 billion program depletes primary dealers’ holdings of Treasuries to the lowest since November 2009.”

Why does this matter?  Because it gives the appearance that the US government is directly funding itself via the Fed’s purchases.  This would be nefarious if it were true and would give credence to the endless complaints about the high rate of inflation in the USA (which is currently running at a staggering 1.5%-2.25% depending on the source).  Fortunately, the concerns are unfounded.

When the US government was working under the gold standard the US Treasury would literally print up certificates to purchase gold from the gold mines.  These gold bars would be delivered to the government and the Treasury would issue a check to the miner.  This new money would end up at the Federal Reserve Bank in the form of deposits.  This would naturally increase the money supply.   An increase in the money supply is scary for obvious reasons.   So, the term debt monetization has its origins in the days of the gold standard, but persists to this day despite the fact that we are no longer on a gold standard.  Not surprisingly, the term is still used today despite the fact that the US government can’t monetize its debt via Fed purchases (I elaborate below).

This issue was magnified yesterday when Richard Fisher of the Dallas Fed invoked the evil “debt monetization” term in his speech:

“the FOMC collectively decided in November to temporarily undertake a program to purchase U.S. Treasuries that, when added to previous policy initiatives, roughly means we will be purchasing the equivalent of all newly issued Treasury debt through June.  By this action, we have run the risk of being viewed as an accomplice to Congress’ fiscal nonfeasance. To avoid that perception, we must vigilantly protect the integrity of our delicate franchise. There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity. The head of the European Central Bank, Jean-Claude Trichet, said it best recently while speaking in Germany: “Monetary policy responsibility cannot substitute for government irresponsibility.”

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases. I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation. And I expect I will be at the forefront of the effort to trim back our Treasury holdings and tighten policy at the earliest sign that inflationary pressures are moving beyond the commodity markets and into the general price stream. I am a veteran of the Carter administration and know how easily prices can spin out of control and how cruelly markets can exact their revenge. I would not want to relive that experience.”

Fisher’s implication is that the Fed is directly helping to fund the US government’s spending.  After all, if they’re buying the debt then they’re obviously funding the spending, right?  Wrong.  As regular readers know, the US government is never constrained in its ability to spend.  Our monetary system underwent a dramatic change when Richard Nixon closed the gold window. It removed any constraint on the US government’s ability to spend.  Nonetheless, the operating structure of the gold standard (issuing bonds, etc) still largely remained intact.

It’s important to understand the Fed and Treasury’s symbiotic relationship.  When the US government wants to spend money they do not call China and ask for a line of credit.  They do not count tax receipts.  And they most certainly do not call the Fed to ensure that we have any money left.  The Treasury is actually able to harness banks as funding agents at all times due to the unique relationship between the banking system, central bank and US government.  So the entire implication that the Fed is helping to fund US government expenditures is entirely inaccurate and anyone who implies as much is still working under the now defunct gold standard model and clearly doesn’t understand the workings of the modern monetary system.  Auctions in the USA don’t fail because they’re designed not to fail.

For a brief instant, Mr. Fisher appears as though he is on the verge of understanding the system he now heavily influences as a new voting member of the FOMC.  Mr. Fisher says that the spending effectively comes first:

“But here is the essential fact I want to emphasize and have you think about today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place….The Fed does not create government debt; Congress does.”

Lights should be going off in Mr. Fisher’s head at this point as he says this. Congress can’t “run out of money” unless it decides to.  That is, the US government is always able to raise the necessary funding through bond issuance if it must (see here for more).  The idea that the US government can’t “run out of money” is so foreign to most people that their minds repel it.

By now you might be thinking that this is all semantics.  Who cares if the Fed isn’t helping to fund the spending?  They’re still buying the bonds and the spending is occurring regardless of the Fed’s actions.  Well, it’s important for several reasons:

1) Someone who understands the modern monetary system understands that a sovereign government with endless supply of currency in a floating exchange rate system has no solvency issue.  Therefore, it should not be treated as if it is a household, business or state.

2) If solvency is not a concern then clearly the concern is inflation or potential hyperinflation.  But as we’ve seen over the last few years the Fed has not succeeded at creating inflation anywhere close to the historical average and certainly not dangerously high levels of inflation.  To someone who understands how the modern monetary system functions it not surprising then, that the Fed has been unable to generate inflation during a balance sheet recession.

3) We have to be very precise about monetary operations and the relationship between the Fed and Treasury.  Although I acknowledge that the US Congress is never constrained in its ability to spend this by no means implies that the US Congress should spend beyond its means.  To do so can possibly result in malinvestment or very high inflation.

4) The idea that the Fed is buying government debt might imply that there are is a shortage of buyers of US debt.  This is impossible due to the government’s symbiotic relationship with the Fed.  Auctions are designed around calculated reserves and are carefully designed so as not to fail.

5) Voting members of the FOMC do not understand the actual workings of the Federal Reserve System and the US monetary system and have played a direct role in the misguided policy response in recent years.  Of course, this is nothing new.  This problem has persisted throughout the entirety of the last 40 years and is largely to blame for the structural flaws in the US economy currently.

6) The overwhelming majority of US citizens have no idea how the US monetary system actually functions and therefore are reluctant or unable to force any sort of real change.  Those with political or monetary motivations tend to invoke fearful language that incites anger and in truth only adds to the problems in the US economy by driving the voter base to react to their emotions and not their knowledge of the system in which they reside.

7) Quantitative easing does not increase the money supply and is therefore not inflationary.  Although this operation can have significant psychological impacts (such as inducing undue speculation) QE can only work in the same manner that traditional monetary policy is implemented at the short-end of the curve.  This occurs by setting a target rate and by being a willing buyer of any size at that rate.  This is NOT how the current policy is designed.  The current structure of QE leaves interest rates entirely controlled by the marketplace and not the Fed.  Therefore, the mixed results should come as no surprise to anyone as the policy was poorly designed to begin with and is likely doing little more than contributing to excessive speculation and promoting the continued financialization of the US economy.  The Fed’s implementation of such policies (such as QE) and complete misunderstanding of such policies does nothing but help create disequilibrium in the marketplace and increase the odds of future instability.

See the QE primer for more details such as the proper discussion of “monetization” with respects to the various QE transactions.


Despite the seemingly strong activity in the economy in recent months there is trouble lurking beneath the surface.   Don’t get me wrong – we have a real recovery on our hands (see here), however, it remains fragile and largely driven by government intervention.  Beneath the surface the balance sheet recession lurks.

As the housing bubble grew the US economy experienced an unprecedented growth in debt.  This generated an imbalance as debt levels far outstripped disposable income.  This environment was sustainable as long as asset prices continued to climb, however, once prices deteriorated debtors were left with an imbalance.  As a result, a balance sheet recession ensued as demand collapsed under the weight of households who preferred to pay down debts rather than spend.  The impact is magnified by corporations that cut costs (read, fire workers) as demand collapses and they attempt to protect margins.  Real sustainable recovery cannot ensue until the indebted sector of the economy returns their balance sheet to a state of normalcy.

The government’s response to the crisis was massive and far more effective than most presumed.  But it was not a cure.  It was merely a temporary fix.  The following updated sectoral financial balances diagram shows what has occurred over the last 15 years.  It’s undeniable that the government response via huge deficits is having a positive impact on the private sector balance sheet:

(Figure 1)

The bright side is that things could have been much worse.  Even better, we haven’t fallen for the fear mongering from the  hyperinflation/USA is bankrupt crowd who are helping to cause so much destruction in the nations of Austeria.  The problem is that this government intervention is not a cure.   Aggregate household debt levels are still too high as evidenced by the debt:disposable income levels (see figure 2).  This means we could still be several years from sustained private sector growth.  As I like to say, the public sector is not yet ready to pass the baton to the private sector.

(Figure 2)

At the current trajectory it’s not unreasonable to assume that the balance sheet recession will last well into 2012 and potentially  longer.  While a 1:1 ratio is “sustainable” by my estimates, it would be comforting to see levels closer to the historical levels in the 80% range.  If that is the case we could see the impact of the balance sheet recession persist far longer than anyone believes. The obvious upside risk is a dramatic improvement in the labor market.  On the other hand, our government is now explicitly encouraging fiscal imprudence in an attempt to “keep asset prices higher than they otherwise would be”.  This sort of policy has the very real potential to increase instability and turn recovery into bubble.  Other exogenous risks (Europe, China, housing prices, etc) also pose substantial risks to the downside.  For now, I think it’s safe to assume that the recovery will remain fairly fragile well into 2012, but given the size of the deficit and potential for labor market improvement we could see continued economic strength.

In sum, it’s clear that government intervention has been sufficient to defer the negative effects of the balance sheet recession.  In the near-term, that is a net positive, however, the risks are substantial.  If the balance sheet recession persists into 2013 or longer then the obvious risk is a substantial decline in the deficit.  Austerity would almost certainly expose an overly indebted household sector and send the economy back into a tailspin.  With the deficit projected to be $1.5T this year it’s comforting to know that we are not repeating the mistakes of Japan, however, it’s important that we not get too complacent as the balance sheet recession lurks underneath a seemingly rosy surface.


“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works”
-  John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867

The release of the Financial Crisis Inquiry Commission’s report contained several enlightening nuggets of information regarding the crisis and its causes, however, none was likely more eye opening than the chart showing the growing discrepancy between compensation in financial services and nonfinancial.

Of course, this is all part of the great financialization of our country.  It would be easy for me to sit here and villanize the financial industry, but we must also remember that this is a function of the current environment.  After all, the government promotes this huge financial industry through lax regulation and consumers have rewarded the financial sector by taking on excessive debt and paying exorbitant fees for their services.  To a large extent the American public is to blame for the excess demand they have attributed to this industry.

Many free market proponents will likely argue that the growth in financial services is a function of demand.  It is the natural progression of the US economy as it has become a wealthy service based economy.  This is a reasonable response.  However, that does not mean it is necessarily good.  As a society we have to ask ourselves if this financial behemoth is sustainable and in the best interest of the future of America?   Are these high rewards disproportionate to their social productivity?   Are we becoming a system that diverts excess capital from long-term investment into short-term unproductive casino-like activities?

This is not to entirely undermine the important role that financial services plays in the US economy, however, I think we can likely all agree that the financial sector has and continues to grow wildly out of control while reaping an inordinate amount of the benefits that the US economy generates.  We must seriously consider whether this wild growth is not disproportionate and now contributing negatively to our future economic prospects.  I believe it is.  How could this mass financialization be negative?

  • Added risk to the economy through business cycle volatility.
  • Talent lost to other more industries which reduces future productivity.
  • Monopolist capitalism results in a growing wealth gap and hoarding of capital by a select unproductive sector.
  • Economic stagnation thru the misuse of capital.

Unfortunately, there are no easy answers to this problem and the USA is clearly not taking any extreme measures to reverse course.  What we need is regulation that helps to ensure that particular entities are not able to detract from the prosperity of the USA.  We need to reduce the Fed’s role in markets so as to close the ties between the central bank and the banks it was created to protect. We need to establish fiscal policy which does not exacerbate the gap between the rich and the poor while also rewarding investment.  We need to establish programs that help educate the public about financial matters so that the public can become less reliant on Wall Street “professionals”.  Clearly, none of this has happened and in fact the USA now appears to be growing back into the same exact animal that existed before the credit crisis.   Truly a crisis wasted….

My point here is not to argue that the financial services industry is useless. The financial services industry greases the engine of capitalism.  That is an incredibly important function.  But we must not become deluded into believing that it IS the engine of capitalism.  If it once again grows to become a disproportionately unproductive portion of the economy there is no reason to believe we aren’t at risk of another major crisis.  I am always bullish about the long-term prospects for America, however, the financialization of this country is one trend which is not only unsustainable, but could prove as the primary roadblock to future prosperity.


Between Paul Ryan’s misguided economic commentary and President Obama’s deficit fear mongering we confirmed that our most important leaders still have no idea how the US monetary system works.  In tonight’s State of the Union President Obama compared the US government to a household even though the two are operationally incomparable.  He said that we need to save at the government level in order to invest despite the fact that a sovereign government with money supply of currency never needs to save or raise funds before spending:

“Now, the final step — a critical step — in winning the future is to make sure we aren’t buried under a mountain of debt.

We are living with a legacy of deficit-spending that began almost a decade ago. And in the wake of the financial crisis, some of that was necessary to keep credit flowing, save jobs, and put money in people’s pockets.

But now that the worst of the recession is over, we have to confront the fact that our government spends more than it takes in. That is not sustainable. Every day, families sacrifice to live within their means. They deserve a government that does the same.

So tonight, I am proposing that starting this year, we freeze annual domestic spending for the next five years. This would reduce the deficit by more than $400 billion over the next decade, and will bring discretionary spending to the lowest share of our economy since Dwight Eisenhower was president.

This freeze will require painful cuts. Already, we have frozen the salaries of hardworking federal employees for the next two years. I’ve proposed cuts to things I care deeply about, like community action programs. The Secretary of Defense has also agreed to cut tens of billions of dollars in spending that he and his generals believe our military can do without.”

Worst of all, he says we need to run a government that is more akin to the deficit fearing government of Dwight Eisenhower – a president who managed to preside over three recessions in just 8 years.  Not surprisingly, Eisenhower helped to promote two budget surpluses that immediately sent the country into recession in 1958 and 1960.  This is not something America should strive for.  Eisenhower was a great man, but an economic guru he was not.

While Obama’s comparisons to a household may make for good political rhetoric and they might appease those who fear monger over the inevitable (and impossible) “bankruptcy of the USA”, the truth is that it is this sort of thinking that keeps the USA from reaching its full capacity and maintaining the economic stability that its citizens deserve.

Hopefully, these “painful cuts” won’t be made until well after this balance sheet recession is over.  For now, this looks like strong rhetoric and nothing more, but it displays a systemic problem in America that begins with the ignorance of our leaders.  Unfortunately, tonight confirmed that our most important leaders still fail to understand the system in which we live and therefore guarantee that millions of Americans will suffer through a continuing boom/bust cycle that inevitably results in unnecessary pain.

Like President Obama’s, Representative Paul Ryan’s comments were just as misguided.  Only this time he raised the oft cited European nations to prove his point:

“Just take a look at what’s happening to Greece, Ireland, the United Kingdom and other nations in Europe. They didn’t act soon enough; and now their governments have been forced to impose painful austerity measures: large benefit cuts to seniors and huge tax increases on everybody.

Their day of reckoning has arrived. Ours is around the corner. That is why we must act now.”

Unfortunately for Mr. Ryan, the Eurozone’s single currency system is dramatically different from our own and his comparison only confirms that he does not understand what he is discussing.  I’ve hammered on this point for a long while now, but this is a message that more people need to begin understanding.  We are not Greece.  We are not Ireland.  The systems are simply not even comparable.  Although the UK is a sovereign issuer of their own currency they were fooled into thinking that they were at the tipping point and yesterday’s negative GDP print proves that they are willingly driving themselves over the cliff edge with austerity measures.  Thus far, we have avoided talking ourselves off the edge of the cliff.  Hopefully, the strong political rhetoric will continue to be ignored and so-called “experts” like Paul Ryan will fail to make any meaningful impact on the US economy.


Markets do not care about you.  They don’t care about your family, your feelings and they particularly don’t care about your wallet.  With record deficits, QE2, 9.4% unemployment, continuing stimulus and 0% interest rates many are still baffled by a surging stock market.  What gives says the Main Street investor?  Clearly, there’s still an enormous disconnect between the market and reality.  I know, there are a lot of positive signs out there, but the fact remains – Main Street still doesn’t feel like the recovery is headed their way.  But the market isn’t the economy.  Main Street isn’t Wall Street.  And the market is a heartless beast that desires one thing and one thing only- PROFITS!

Although we live in a world of the Bernanke Put and endless government bailouts the markets remain the last bastion of natural selection in the modern world.  When allowed to truly function on its own capitalism is a cruel, heartless, but remarkably efficient bitch.  The weak ultimately perish and the strong survive.  For the strong the rewards are great.  For the weak the losses are insufferable.  And in this world of cruelty you must never forget that the system has no sympathy for you or your emotions.

The equity market is priced based on future profit expectations that are often right, but more often than not prove to be wrong.  As we saw in 2007 those expectations were high, investors believed economic downturn would be thwarted and the environment ultimately surprised substantially to the downside.  As the waterfall decline ensued we experienced the inverse reaction in 2009.  Markets and expectations overshot to the downside.  Expectations for profit growth became far too low and classic mean reversion ensued.  As the economy stabilized in 2009 the economy remained stagnant at best.  But the economy’s loss had become corporate America’s gain.  The massive cost cuts made these corporations lean and mean.  Corporate America’s diverse revenue stream kicked in as the global economy strengthened and leveraged up these lean balance sheets.  Despite persistent weakness in the US economy profits continued to rebound through 2009 & 2010 even as US unemployment continued to climb.  That heartless bitch did not care about the unemployed, stagnant wages or l-shaped recoveries.  She cared only for the bottom line and the bottom line was robust – particularly when compared to expectations.

Over the years I have attempted to measure this disconnect between perception and reality using my Expectation Ratio.  The metric was bearish since 2007 and was then bullish throughout the majority of the recent bull market. If I have made one mistake in recent years it has been focusing on what should be good for an economy (job growth, fair markets, organic growth, etc) as opposed to what the market desires (higher profits no matter how they come). But much like an approach to trading, your approach to conducting research must be unbiased, flexible and mechanical.  Ultimately, the purpose of research is to generate investment profits.  Connecting the dots between this research and actionable ideas is vital to success.  If you allow the emotion of a macro outlook to infect your work your results will suffer.   Remember, the market is not the economy.  The market does not care about the emotions of the unemployed or the suffering.  In fact, she feeds off the negative emotion and it is often not until you have become comfortable and complacent that she will turn her back on you and break your heart again.

As investors we are always learning, evolving and honing our skills in order to avoid the pitfalls that cause so many to self destruct. Few investment cycles have been as great a learning experience as this one.  We live in a renaissance for economic thought, economic theory and investment.  It’s unlikely that we will experience as many beneficial learning experiences as the most recent cycle.  And while this environment continues to cause great pain there are also great lessons to be learned.

From an investment perspective, there has been no greater lesson than the fact that has been burned into my soul from the last 24 months – the market is not the economy and the market has no sympathy for you, your family or your emotions.  She desires one thing and one thing only – profits.  And those profits will often come at the expense of everything we wish for in this world.  That’s the cruel reality of the capitalist system in which we reside.  It might not be fair, it might not be right, but it is what it is.  In the end, capitalism continues to be the most dynamic, innovative and productive system in the world.  But make no mistake – that system does not care about you and anyone who forgets that will be devoured by it.