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Stanley Druckenmiller is Very Worried About US Government Debt

Stanley Druckenmiller, the great money manager who made a fortune trading with George Soros and running his own firm thereafter, is on a media blitz regarding the trajectory and sustainability of US government debt.  He claims that a crisis far larger than 2008 is on the horizon.  I wasn’t going to comment on this piece in the Wall Street Journal from a few weeks back, but I can’t seem to turn on the TV or pick-up a newspaper without seeing similar pieces or interviews by Mr. Druckenmiller.

I should start by saying that it’s clear that Mr. Druckenmiller is a great macro investor.  But I am fairly confident that he’s misinterpreting a few things here.  First of all, his WSJ piece sends up a few red flags.  For instance, the piece says:

“First, the country’s existing entitlement programs are not just unaffordable, they are also profoundly unfair to those who are taking their first steps in search of opportunity.”

Unaffordable is an unfortunate way to describe this.  Let’s remember how the US monetary system is designed.  In this country, government spending is ALWAYS a redistribution of existing money.  Our money system is designed around banks who create almost every dollar in the economy.  If you want to call something “money printing” you should call the loan process “money printing”.  The government is what Monetary Realism refers to as a “strategic currency issuer” in this system.  That is, it is a self determined user of bank money, but never has a problem procuring funds.  When the government taxes you they take Peter’s bank money (inside money because it’s created by banks INSIDE the private sector) and redistributes it to Paul.  When the government deficit spends (spends in excess of tax receipts) it gives a t-bond to Peter who gives the government inside money and the government redistributes the inside money to Paul.  The private sector has a net financial asset in the form of the t-bond (that is, there is no corresponding private sector liability), but the amount of actual inside money is exactly the same after deficit spending as it was before.  It just got redistributed.

Is this process of taxation and deficit spending “unaffordable”?  It’s only unaffordable if you believe that the government will run out of its ability to tax or deficit spend.  Of course, the tax system could collapse, but that’s only likely in a hyperinflation, which is a highly unlikely scenario in the USA due to huge amounts of output and continually weak aggregate demand (in addition to a lack of real money printing by banks, ie, we’re in a balance sheet recession still).  The US government’s ability to sell bonds is also not at risk for several reasons.  First, the Primary Dealers are required to make markets in US government debt.  If they want to be in the Primary Dealer system and reap the rewards of the system, they have to abide by the rules.  The only situation in which they might revolt against the US government is in a hyperinflation, which is unlikely.  The Dealers are always able to sell these bonds because of the attractiveness of US government paper.  That is, in an environment where asset risks and economic growth remain high, anyone with a 0% interest bearing savings account is clamoring to find any interest at all.  Long bonds, which yield just over 3% and provide a risk-free return (aside from loss of purchasing power) look pretty good in comparison.  So, the ability to procure funds is never an issue except maybe in a worst case hyperinflation scenario.

In addition, the US government always has a rescue valve if it should ever need money.  As a strategic currency issuer the US government can always call on its central bank to create the money it needs.  Some foreign governments (such as Canada) already have central banks buying bonds in the primary market (as opposed to the secondary market as the Fed does).  So a debt that is denominated in a money you can theoretically create, does not create a solvency risk.  But of course, there’s no free lunch here.  The US monetary system could certainly fall victim to inflation risk and credit disequilibrium.  But these are very different problems than not being able to “afford” something in the sense that I cannot afford to buy 10 Ferraris today.

He goes on to mention the national debt clock, which is a fearmongering tool of epic proportion:

….

Second, while many in Washington pay lip service to the long term, few act on it. The nation’s debt clock garners far less attention than the “fiscal cliff” clock.

But what about the national wealth clock?  The US private sector has amassed a net worth of over 65 trillion dollars.  Why does no one ever point that out?  We are a phenomenally wealthy country.  The national debt is a piece of the private sector’s overall net worth (those savings bonds represent a big piece of grandma’s saving).  So we have to keep this conversation in perspective.  The national wealth substantially dwarfs the national debt.

Could government spending “water down” the private sector’s ability to produce growth, possibly increase inflation and cause disequilibriums in the US economy?  Yes.  I am not saying that there is no potential ill-effects of government spending.  But the question of “affordability” and debt needs to be kept in the proper perspective.  The USA has an inflation constraint. Not a solvency constraint.   And if you’re worried about high inflation in a world where the real money printers aren’t printing because their clients are recovering from a debt crisis, then you’ve probably misunderstood the operational realities of the US money system.

Is A “Great Rotation” Underway?

The following is an excerpt from a recent Orcam Investment Research piece:

Thoughts on the “Great Rotation” 

It’s been difficult to escape discussion about the “great rotation” in recent weeks.  In case you’ve been hiding underneath a rock, the idea of the “great rotation” is that investors are presently in the process of “rotating” out of bonds and into stocks.  There are three big misunderstandings being made behind this thesis:

  • First, investors don’t “rotate” out of stocks and into bonds.
  • Second, the end of the bond bull implies an end to easy Fed policy.
  • Third, the bond bull has been weaker than most presume.

The first point is a very fundamental fact about secondary markets.  We must understand that all securities issued are always held by someone.  There is no such thing as “getting out of” stocks or bonds.  You can sell to someone else who exchanges you their cash position, but in the aggregate there is no such thing as “getting out of” stocks and moving into bonds.  All securities issued are always held by someone.  It’s better to think of money as moving through securities and not into them.

Ultimately, what determines the price of these securities is the desire of the buyers and sellers to acquire or dispose of those securities.  But the idea of a “great rotation” is a great misnomer.  It implies something similar to switching from Makers Mark to Jim Beam as your preferred form of whiskey.*   But stocks and bonds are not consumer products that we can switch in and out of.  They are savings vehicles issued as liabilities of the entities who issue them and they are always held until retired.

The second point revolves around the idea that government bonds are no longer an attractive asset class.  This might make sense were it not for such an accommodative Fed policy.   Ultimately, Treasury Bond prices are pegged to economic conditions and the Fed’s perception of economic conditions.  Bond traders will adjust their holdings of Treasury bonds based on their perception of future Fed policy.  But future Fed policy is contingent upon future economic conditions.

Thus far, the Fed has been very clear about future policy due to the continuing weak economic environment.  They will not ease off the accommodative pedal until they see 6% unemployment.  That means we’re staring at a 0% Fed Funds Rate for the foreseeable future.  Since long rates are an extension of short rates I wouldn’t expect huge deviations in t-bond prices unless we see a roaring economy in the coming years (IF we see a roaring economy at all).  And while I’ve long been optimistic about the economy I would not peg high odds on the sort of growth that would lead to 6% unemployment in the coming 12-18 months.

It’s also helpful to put this into perspective by looking at the current guesses of those bond traders trying to front run the Fed.  At present the Fed Funds Futures curve is much steeper than it was just a few weeks ago (see figure 1).  Traders are now pricing in a rate hike as soon as early 2015.  I think this is probably optimistic.

(Figure 1 – via Orcam Investment Research)

The risks to the US economy will remain many in the coming years as the Balance Sheet Recession lingers and government spending slows.  It’s also highly unlikely that the unemployment rate will drop below 6% before 2015.  That likely means the bond market is overly optimistic about future rate hikes and we’re likely to see that curve shift to a flatter position.

Lastly, I think it’s important to keep the bond bull market in perspective.  Since 1928 the average annual return on Treasury Bonds was 5.4%.  Meanwhile, the trailing 10 year returns on Treasury Bonds has been 5.76%.  In other words, the recent returns have been far lower than most presume and much more in-line with the average annual return.  While it wouldn’t be surprising to see this rate of return revert further to the mean I think it’s a stretch to imply that the bond market is as deeply into “bubble” territory as we constantly hear about.

(Figure 2 – via Orcam Investment Research)

In sum, I think it’s important not to get too caught up in these dramatic sort of concepts that imply we are presently in the middle of some sort of paradigm shift.  Bonds aren’t going away.  They’re not going to become a less important part of people’s portfolios.  Investors aren’t “getting out” of bonds.  And while the next 10 years are not likely to be as favorable to bonds as the last 10 years I wouldn’t fall victim to the idea that you need to dramatically shift your portfolio to account for what sounds more like a marketing ploy than sound advice.

*  While we are not in the business of providing specific investment advice to clients, we would highly recommend against ever making this “rotation”. 

 

 

Did Keynes Understand Endogenous Money?

One of the core understandings of MR is the endogeneity of money. Endogenous money is based on the understanding that the money supply is high powered money + broad money and that these variables are determined by the private sector’s demand for money. That is, almost all of the money in our monetary system is created by banks almost entirely independent of the government.  It is created INSIDE the private sector.  The government has essentially outsourced the creation of money to a private oligopoly of banks who compete for business.  This fact is largely untouched in most of mainstream economics.  And there might be a fairly good reason why.

JM Keynes is clearly one of the most influential economists of all-time.  Perhaps THE most influential economist of all-time.  His General Theory is a veritable bible for many economists.  So it’s interesting to note that while many economists during the era of Keynes were aware of the endogeneity of money (Soddy and Fisher for instance), Keynes himself appeared extremely confused on the subject.  In the General Theory he wrote:

We can sum up the above in the proposition that in any given state of expectation there is in the minds of the public a certain potentiality towards holding cash beyond what is required by the transactions-motive or the precautionary-motive, which will realise itself in actual cash-holdings in a degree which depends on the terms on which the monetary authority is willing to create cash.

“In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed.”

Thus we can sometimes regard our ultimate independent variables as consisting of (i) the three fundamental psychological factors, namely, the psychological propensity to consume, the psychological attitude to liquidity and the psychological expectation of future yield from capital-assets, (2) the wage-unit as determined by the bargains reached between employers and employed, and (3) the quantity of money as determined by the action of the central bank

These are various forms of a money multiplier or government centric money system and they’re inapplicable to the way the system is actually designed.   It’s clear that JM Keynes did not have a solid grasp of endogenous money.  And perhaps that explains why so many modern day economists and economic models simply ignore the reality that banks rule the monetary roost.    Perhaps the confusion over so much of modern macro stems directly from the master himself?   Was the most influential economist of our times actually woefully misinformed?  It appears so….

“Loans Create Deposits” – In Context

By JKH (cross posted at Monetary Realism)

Introduction

Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Systems

The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system. These restrictions include central bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and pricing of bank reserves that are consistent with the monetary policy interest rate target) and other guidelines (such as the reaction function of the policy rate to various measures of inflation, output, or employment). The full category of potential constraints is broad and varied. But none of this alters the fact that a monetary system is basically a bookkeeping device for the intermediation of real economic activity. It is a construct that enables moving beyond a barter economic system that can only be imagined as a counterfactual.

The Choice for Banking

Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the system include a competitive banking sector? More broadly, will financial capitalism exist in substance and form? Will there be competition? Within this landscape, will there be more than one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding how banks actually work. The competitive framework that is often taken for granted is in fact a choice for banking system design – including the presence of a reserve system that enables active management of individual bank balance sheets.

‘Loans Create Deposits’

When we say ‘loans create deposits’, we mean at least that the marginal impact of new lending will be to create a new asset and a new liability for the banking system – typically for the originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a new bank liability. Both of those accounting entries represent increases in their respective categories. This is operationally separate from any notion of reserves that may be required in association with the creation of bank deposits.

In another version of the same lending transaction, the lending bank presents the borrower with a cheque or bank draft. The lending bank debits the borrower’s loan account and credits a payment liability account. The bank’s balance sheet has grown. The borrower may then deposit that cheque with a second bank. At that moment, the balance sheet of the second bank – the deposit issuing bank – grows by the same amount, with a payment due asset and a deposit liability. This temporary duplication of balance sheet growth across two different banks is captured within the accounting classification of bank ‘float’. The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability. The end result is that the system balance sheet has grown by the amount of the original loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in different banks. The system has expanded in size. The growth is now reflected in the size of the deposit issuing bank’s balance sheet, with an increase in deposits and reserve balances. The lending bank’s balance sheet size is unchanged from the start (at least temporarily), with loan growth offset by a reserve balance decline.

Money Markets

In this latter example, it is possible and even likely, other things equal, that the lending bank additionally will seek to borrow new funding from wholesale money markets and that the deposit issuing bank will lend funds into this market. This is a natural response to the respective change in reserve distribution that has been created momentarily for the two banks. Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal. Adjusting positions through money market operations is a basic function of commercial bank reserve management. Thus, this example features the core role of bank reserves in clearing a payment from one bank to another. The final resolution of positions in this case is that the balance sheets of both banks will have expanded, indirectly connected through money market transactions that follow on from the initial ‘loans create deposits’ transaction. However, this too may be a temporary situation, as the original transaction involving two different banks will inevitably be followed up by further transactions that shift bank reserves between various bank counterparties and in various directions across the system.

The Money Multiplier Fable

The money multiplier story – a fable really – claims that banks expand loans and deposits on the basis of a central bank function that gradually feeds reserves to banks, allowing them to expand their balance sheets with new loans and reservable deposits – according to reserve ratios that bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of course. In fact, bank balance sheet expansion occurs largely through the endogenous process whereby loans create deposits. And central banks that impose reserve requirements provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred. The multiplier fable describes a central bank with direct exogenous control over bank expansion, based on a reserve supply function – which is a fiction. The facts of endogenous money creation have been demonstrated by empirical studies going back decades. Moreover, the facts are obvious to anybody who has actually been involved with or closely studied the actual reserve management operations of either a commercial bank or a central bank. In truth, no empirical ‘study’ is required – the banking world operates this way on a daily basis – and it is absurd that so many economics textbooks make up stories to the contrary. The truth of the ‘loans creates deposits’ meme is pretty well understood now – at least by those who take the time to learn the facts about it.

Central Bank Reserve Injections

A central bank that imposes a reserve requirement will follow up new deposit creation with a system reserve injection sufficient to accommodate the requirement of the individual bank that has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the central bank. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. Thus, there is a lag between two system growth impulses – ‘loans create deposits’ as the endogenous feature and a subsequent central bank reserve injection as an exogenous follow up. The required reserve injection is typically small by comparison, according to the reserve ratio. The central bank can provide the reserves in different ways, such as by purchasing bonds or by conducting system repurchase operations with investment dealers. In the case of either bond purchases or system repurchase agreements, additional system deposits might be created when the end seller (or lender) of the bonds is a non-bank. And that second order creation of deposits may be reservable as well. But what might appear to be a potentially infinite series of reserve injections is in fact highly controlled in the real world – because the reserve ratio is relatively small. Some countries such as Canada have no such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the nature of the money multiplier as an annoying analytical error and distraction from accurate comprehension of how banks actually work. But as a separate point, central bank injections of required reserves illustrate how not all deposits are necessarily created by commercial bank loans. ‘Loans create deposits’ is true, but not exclusive. This aspect is made clear also by the example of central bank ‘quantitative easing’, noted further below.

The Growth Dynamic

The ‘loans create deposits’ meme is best understood as a balance sheet growth dynamic, distinct from any reserve effect that might occur as part of an associated interbank clearing transaction at the time (e.g. the second example above) or as part of a deposit ratio requirement that might be activated at a later date. The banking system can be visualized in continuous time, punctuated by discrete banking transactions that are reflected as accounting entries. If one divides time into very small time intervals, individual banking transactions can be isolated as the only transactions that occur during a given interval of time. Thus, the growth dynamic of ‘loans create deposits’ can be conceived of as an instantaneous balance sheet expansion at the point of corresponding accounting entries. As noted in the examples above, this expansion may then migrate across individual banks when the lending and deposit issuing bank are different.

‘Deposits Fund Loans’

Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.

There is no inconsistency between the idea that ‘loans create deposits’ and the idea that banks need deposits to fund loans. Bank balance sheet management must respond to both growth dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types – including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the central bank is not a mere slush fund that provides unlimited funding to the banking system. In fact, active liability management is important in private sector banking – in the system we actually have. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists. Some analysts tend toward language that conflates factual and counterfactual cases in this regard. To repeat – bank liability management is very competitive in the system we have, by design. The ‘loans create deposits’ meme, while true, only touches on this competitive dynamic.

We note again that loans are not the sole source of deposit creation. A commercial bank’s purchase of securities from a non-bank will typically result in new deposit creation somewhere in the system. There are cases where deposit creation results from other liability or equity conversion – commercial bank debt redemption and stock buybacks are examples of this. Existing fixed term deposits can convert to demand deposits and vice versa. And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits. Nevertheless, ‘loans creates deposits’ is a reasonable reference point and standard for the process of deposit creation.

Bank Asset-Liability Management

The ‘loans create deposits’ dynamic comprises the production of much of the money that serves as a basic source of liquidity in a monetary economy. The originating accounting entries are simple – a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital – especially equity capital – to take risk – and to take credit risk in particular.

Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The ALM function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities.

The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity.

In examining all of these effects, it is helpful to consider the position of the banking system in its totality, in conjunction with the position of individual banks that constitute the whole. For example, the US commercial banking system is composed of thousands of individual banks. Between discrete ‘loans create deposits’ events, the banking system is in continuous balance sheet churn. Specifically, deposits are moving back and forth between individual banks, as a matter of normal payment system operations. They are also moving and inter-converting in the form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds economic activity of all sorts, where households, businesses, and governments are making payments to each other for various goods and services and other types of transactions, and are making choices about the portfolio structure of their liquid assets. This is the core liquidity provided by the banks to their customers. And this is the stuff that involves a good deal of transferring of reserves back and forth between banks, in order to affect accounting completion of balance sheets that are in continuous flux in size and composition.

Bank Reserve Management

The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets that are in balance, institution by institution – and where deposits fund loans, alongside various other asset-liability matching configurations. The reserve system records the effect of this balance sheet activity. The reserve account is the inverse exogenous money image of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset liability management coordination in order to match up assets and liabilities both in nominal terms and in a way that is financially effective. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis.

Conclusion

In summary, the original connection by which deposits are created by loans typically disappears at some point following deposit creation – at the micro bank level and/or the macro system level. The original demand deposits associated with specific loan creation become commingled as they move back and forth between different banks. And they not only move between banks, but they can change in form within any bank. They can be converted into term deposits or other funding forms such as bank debt or common and preferred stock. The task of dealing with this compositional flux falls under the joint coordination of bank asset-liability management and reserve management. The overarching point of observation is that both system growth and system competition for existing balance sheet composition are in constant operation. ‘Loans create deposits’ only describes the marginal growth dynamic at the inception of deposit creation. ‘Deposits fund loans’ is the more apt description that applies to a good portion of what constitutes ongoing balance sheet management in competitive banking.

Barrons Doesn’t Do Monetary Realism

Just when you think the word might be spreading….It was interesting that Barrons ran this great quote from a regular reader here at Pragcap last week:

 We must be careful comparing the federal government with a household (or state or business) because Washington has no solvency constraint. The federal government can’t run out of money (unless Congress decides it should), as it can always call on the banks and the Federal Reserve to serve as agents of the government.

The constraint is inflation, not solvency. But given the weakness in our economy, along with high unemployment, I don’t see much risk of inflation anytime soon.”

And then just a week later runs a cover piece about how the USA is becoming Greece.   Of course, the problem within Europe is that their central bank is entirely independent of the sovereigns rendering none of the European countries pure currency issuers.  They are all strategic users of the Euro because of this lack of political and monetary union between Treasury, Central Bank and government.  The USA, of course, doesn’t have this problem so it is virtually impossible (aside from political choice) for the USA to run out of money.  The comparison Barrons makes is patently wrong.  For a full discussion on this arrangement with a comparison of Greece and the USA please see the section called “Contingencies – The USA versus Europe” in the Contingent Institutional Approach.

Anyhow, the Barrons piece could be right about some things.  Yes, government spending could cause big problems down the road and it might even cause high inflation.  But what it isn’t going to causes is a Greek-like crisis where market participants literally worry that we are running out of money.  It won’t happen in the USA where the true constraint is inflation, not solvency.  

Japan Does the Full Ponzi

I saw this headline over at Calculated Risk regarding the new “monetary policy” in Japan:

And from the Japan Times: Japan’s economic minister wants Nikkei to surge 17% to 13,000 by March

Economic and fiscal policy minister Akira Amari said Saturday the government will step up economic recovery efforts so that the benchmark Nikkei index jumps an additional 17 percent to 13,000 points by the end of March.

“It will be important to show our mettle and see the Nikkei reach the 13,000 mark by the end of the fiscal year (March 31),” Amari said in a speech.

The Nikkei 225 stock average, which last week climbed to its highest level since September 2008, finished at 11,153.16 on Friday.

“We want to continue taking (new) steps to help stock prices rise” further, Amari stressed …

I think this is remarkably silly policy.  It’s the worst abuse of central bank powers and based largely on a misunderstanding of secondary market dynamics.   I wish wealth creation was as easy manipulating stock prices.  Then every country in the world could just have their central bank target a market price and presto-changeo – we’re all rich!  Nevermind if the underlying corporations don’t actually justify the valuation!  After all, the central bank says the cash flows justify THIS price.  They said so!

Of course, this isn’t how reality works.  The stock market is made up of companies selling at a nominal price on exchanges and all shares outstanding are always held by someone looking to find someone else to sell to so the current holder can realize gains (which subsequently leaves the new holder with the exact same problem searching for the next person in line).  Those prices are determined primarily based on the eagerness of the participants in those markets to buy or own shares based on the expected future performance of the actual underlying corporations.

We can implement policy that causes these prices to deviate from where the market would have otherwise set them (largely by making participants more or less eager to own shares).  But what is the point of this?  What does this do other than cause disequilibrium if it does not cause an equal change in the underlying business?  If the market believes the Nikkei is worth 11,000 based on expected future fundamentals then pinning the price at 13,000 only causes a short-term disequilibrium that will result in the same amount of eventual wealth lost that is presently being gained.

Again, stock markets are nominal wealth.  Someone must always hold shares of stock outstanding so someone will always be concerned that they’re left holding the ponzi scheme at the peak if that’s in fact what the central bank explicitly targets.   And that leaves the same underlying downside reversal risks present at all times.  Yes, the Bank of Japan might create some real wealth (for some market participants) in the near-term and might thereby make Japan appear better off than they really are, but there’s absolutely no underlying fundamental change in the corporations that make up this index that should lead one to believe that these price changes are justified.  And when the Ponzi scheme is exposed the market collapses thereby destroying wealth for all the current participants leaving us right back where we started.

This is ponzi based monetary policy.  It’s based on a false understanding of market dynamics, a false understanding of real wealth, and it’s very likely to cause disequilibrium in the long-term.

See also: The Destabilizing Force of Misguided Market Intervention

QE & Stock Prices – A Review of Recent Data

One of the primary goals of Quantitative Easing is the portfolio rebalancing effect and subsequent wealth effect that supposedly occurs as the Fed reduces outstanding private sector bond holdings and forces investors to chase returns up the risk spectrum into other asset classes to replace lost potential real returns.  I won’t discuss the aspects of “money printing” and “debt monetization” here (which I think the mainstream gets mostly wrong), but rather, I’d like to focus on the pure data between periods when reserves are increasing and stock returns.

We’ve now had over 4 years of varying forms of QE so the data is quite a bit more constructive than at times in the past when most of us were just speculating about QE’s impacts.  At first glance, the chart below might lead one to conclude that there is a very strong correlation between between QE and equity market returns, but the data is not so conclusive upon closer inspection.  This has been due to the way the programs were implemented in staggered steps over the years with periods of buying tending to be rather short.  Contrary to popular opinion, during the majority of the time in the last 4 years reserve balances have been stagnant or even declining.  On a weekly basis, reserve balances have been rising just 47% of the time and have actually been declining 53% of the time.

Since QE began in late 2008 there’s a correlation between reserve balances and stock returns of just 0.65.  But that’s not a completely fair look at the data.  There have been four distinct periods when reserve balances were surging or declining/stagnant over the last 4+ years.  I’ve broken this down more clearly below.

Periods when reserve balances were increasing includes (on a weekly basis):

9/10/2008 – 1/7/2009

2/11/2009 – 5/20/2009

6/24/2009 – 2/24/2010

11/17/2010 – 7/13/2011

Periods when reserve balances were declining substantially include:

1/7/2009 – 2/11/2009 (reserve balances fell by 31%)

5/20/2009 – 6/24/2009 (reserve balances fell by 12.5%)

2/24/2010 – 11/17/2010 (reserve balances fell by 20%)

7/13/2011 – 9/26/2012 (reserve balances fell by 15%)

What’s interesting here is that the correlation between stock returns and decreases or increases in reserve balances is not quite as clear cut as most presume.  See below for returns during reserve balance increases:

9/10/2008 – 1/7/2009 (S&P 500 DECLINED by 25%)

2/11/2009 – 5/20/2009 (S&P 500 INCREASED by 6%)

6/24/2009 – 2/24/2010 (S&P 500 INCREASED by 22%).  

11/17/2010 – 7/13/2011 (S&P 500 INCREASED by 11%).  

That looks pretty much as we might expect.  But things get more interesting when we look at periods when reserve balances were declining:

1/7/2009 – 2/11/2009 (S&P 500 DECREASED by -10%)

5/20/2009 – 6/24/2009 (S&P 500 INCREASED by 1%)

2/24/2010 – 11/17/2010 (S&P 500 INCREASED by 8%)

7/13/2011 – 9/26/2012 (S&P 500 INCREASED by 9%)

In other words, regardless of whether reserve balances were rising or falling, stock prices were mostly rising.  Even in the face of substantial declines in reserve balances over the last 4+ years the S&P 500 has risen.  Of course, there are a lot of moving parts in this data, but the correlation between stocks and reserve balances is not terribly clear when we get granular with the data.

( Chart via Orcam Investment Research)

Robert Shiller: Don’t Invest in Housing

Robert Shiller of Yale was on Bloomberg yesterday discussing housing and his general outlook. But the most interesting comments were with regards to his general view of housing as it pertains to your overall portfolio. Shiller said that investing in housing was a “fad” and not a great historical investment. Of course, if you’re familiar with his long-term real returns chart  (see the chart in #9 here) housing generally generates returns that are in-line with inflation. US residential real estate just isn’t a great investment in real terms. Shiller explains why:

“Housing is traditionally is not viewed as a great investment. It takes maintenance, it depreciates, it goes out of style. All of those are problems. And there’s technical progress in housing. So, the new ones are better….So, why was it considered an investment? That was a fad. That was an idea that took hold in the early 2000’s. And I don’t expect it to come back. Not with the same force. So people might just decide, ‘yeah, I’ll diversify my portfolio. I’ll live in a rental.’ That is a very sensible thing for many people to do.

…From 1890 to 1990 the appreciation in US housing was just about zero.  That amazes people, but it shouldn’t be so amazing because the cost of construction and labor has been going down.

…They’re not really an investment vehicle unless you want it for your personal reasons.”

This is a contentious debate.  In strict economic terms housing is viewed as investment and not consumption.  That’s why the BLS doesn’t include house prices in the CPI.  Even though housing includes fixed investment, you’re really consuming your house over the course of many years so there’s elements of both consumption and investment in housing.  The reasoning Dr. Shiller uses here is a big part of the consumption.  A house is a depreciating asset even though the land might not be.

Obviously, there are a lot of moving parts here and I am not sure I completely agree with Dr. Shiller.  Well run rental properties and commercial properties can be good investments, but most of us are living in our homes.  We’re consuming our home one day at a time and hoping that the scarcity of housing and land will result in prices outperforming inflation.  But there’s a flaw in that thinking also.  Because housing is such a large portion of most people’s expenses it has a very close connection with wages which have a very close connection with inflation.  So it’s not surprising to see house prices revert to the mean when they diverge from the annual rate of inflation – in general, that’s a sign that prices aren’t supported by incomes.

Personally, I prefer to think of a house as a place that provides intangible benefits and not investment benefits.  You buy a house because it puts a roof over your head.  You buy a house to live in it, not to invest in it.  But, like commodities, housing has become its own “asset class” that Wall Street has packaged up and sold to the American public as an equivalent to buying 500 of the best companies in the world (the S&P 500).   Most people also don’t invest in the stock market, but that’s a different discussion….I wouldn’t go so far as to say that real estate can’t be a good investment for some people (mostly experts), but for most of us the odds are that “investing” in real estate is not the right way to think about things.

I’d love to hear reader thoughts on this topic….