Archive for Myth Busting – Page 2

The Not So Great Rotation

Remember all that chatter earlier this year about the “great rotation” and how bonds were going to get crushed because everyone was “rotating” into stocks?  That seems to have died down quite a bit in recent months, but just to put a nail in that coffin I wanted to point to the actual data.

But first, let’s remember a basic macro lesson – all securities issued are always held by someone.  If you sell your stocks to “rotate” into bonds then someone else is selling their bonds to “rotate” into stocks.  In the aggregate, people don’t “rotate” out of existing financial assets and into other financial assets.  They simply exchange financial assets and the value of those assets may or may not change in the process.  That’s simple enough, right?

But that’s only the secondary market.  What about the primary market where actual issuance is occurring?  Well, the “great rotation” myth looks even more ridiculous if you look at the data there because the issuance of debt in the USA has massively dwarfed the issuance of equity in recent years.  And it not’s just government related debt.  Corporate debt has outpaced equity issuance by a huge margin (roughly 10:1 per month over the last 2 years).

Here’s the chart showing monthly issuance of corporate debt, corporate equity and total bond market issuance.  As you can see, this one pretty much puts the nail in the “great rotation” coffin.

rotation_not

Most Index Funds are Macro Funds

I’ve been having a good discussion on Twitter with Tren Griffin about indexing and value investing.  Value investors are stock pickers.  They think they can find the buried gems in the market that others can’t find.  It’s certainly possible.  And Tren agrees that only about 5% of people are any good at it.  And that’s the thing, it’s not realistic for most people to rely on such an approach.

What I find interesting though, is that most people don’t think of index funds as macro investing.  But what is an index fund?  An index fund is just an inactive bet on a macro trend.  If you buy the S&P 500 index you’re basically making a bet on corporate America.  If you were to combine that with an aggregate bond index you’d simply be diversifying your bet on corporate America.  But the point is, you’re still making a macro bet that corporate America will do well.  You’re not making micro bets.  And if you diversify even broader then you’re just extending this macro bet to other markets.  If you bought the Vanguard Total World Index and combined it with an aggregate bond index you’re just placing a global macro growth bet.  That’s all.  In other words, index funds are mostly just macro funds.  I call them “lazy macro” strategies.  And lazy portfolios are just fine for most people.

Of course, there’s varying degrees of macro investing.  You can be extremely passive like the John Bogles of the world.  Or you can be more strategic and tactical like the Ray Dalios of the world.  Either way, it’s all macro….And that’s the future of the world.  Macro.  As I always say, it’s a macro world and we’re all just living in it.

The Debt Bad Guys

The recent post on who owns the Federal Reserve caused all the standard responses:

  • I am an idiot.
  • I am a shill for the Fed.
  • The Fed is owned entirely by the banks.
  • The banks are all evil.

And then, one of my favorites:

  • Debt is always bad.

First off, I am an idiot some times.  So let’s just get that out there.  Second, I don’t work for the Fed.  Third, the Fed issues shares, but those shares have no voting rights and are a claim on only a small slice of the Fed’s annual profits so if you want to call that “ownership” then that’s right, but it is wrong to imply that the Fed is entirely owned by the private banking system.  Fourth, banks, like most capitalist entities, can sometimes do greedy and terrible things in the pursuit of profit.  Welcome to capitalism.  Enjoy your stay.

That last one is really misleading though.  What is debt?  Debt is issued because a loan is issued by a bank or some other entity.  In the case of a standard bank loan the borrower is spending in excess of his/her current income.  In other words, you’re pulling your future spending into the present.  In return for this favor, the bank charges you an interest rate to cover their risk that you might not repay them the money you borrowed.  That’s all basic enough.

But is this really a bad thing?  It depends.  If I want to buy the new iPhone 5C, a new Tesla, the biggest McMansion on the block and all the other gadgets and gizmos that modern Americans seem to obsess over then I might need to spend more than my current income.  And the bank gives me access to funding by agreeing to let me pull my future spending into the present so I can enjoy a better living standard than I can afford on my current income.  If I pay off the loan on time then I get to experience a better living standard and the bank gets rewarded with a profit.  Everyone wins.

Some people, for some reason, act like banks FORCE us to borrow money from them at all times.  Of course, you don’t HAVE to always live beyond your means.  It’s something a lot of Americans just choose to do.  I mean, we could probably afford to just live in tents, drink water and eat beans and rice all day every day.  But that would be boring and miserable.  Debt gives us access to something more than we could otherwise have.  Debt is sort of like travelling into the future.  Which is pretty amazing.  The problems only arise when you get greedy and input false estimates into your Flux Capacitor and everything breaks down and you get sent to the wrong year.

Debt can be a very bad thing if it’s abused.  But in a lot of ways debt is also an amazing thing.  It all depends on how we use it.  If you use it like a greedy fool then it will serve you poorly.  If you use it prudently it can serve you well.  So no, banks aren’t necessarily bad guys just for making debt available to us all.  After all, if banks didn’t do it then someone else would because there will always be people who want to live beyond their means.  And then when this person charged interest for this favor you’d see the same people complaining about how this person is a “rentier” or whatever.  In the end, the people screaming about debt either don’t understand it entirely or have a political axe to grind.  And neither are very useful for much of anything except creating a lot of traffic to useless internet sites.

NB – Feel free to use the comments section to complain about the evils of debt or theorize about which bank or central bank I am working with.  If possible, try to turn on the caps lock and be as vulgar as possible.  Thanks.  

NB II – If you would like to experience a thorough demolition of all these Federal Reserve conspiracy theories from books like The Creature From Jekyll Island then please go here and spread it around so people stop referring to this perpetual nonsense.  

Who Owns the Federal Reserve?

Good question here in the Ask Cullen page.  I get this one a lot so it’s worth some detailed explanation.

First, it helps to understand what the Fed really is.  The Federal Reserve System was modelled after the New York Clearinghouse that existed in New York during the 1800′s and 1900′s.  As its name states, the New York Clearinghouse was just a big clearinghouse where many of the big banks would come to settle their interbank payments.  Unfortunately, it wasn’t broad enough to handle the scope and complexity of the US banking system so these regional clearinghouses were deficient in dealing with banking crises and liquidity issues.  The Fed System took this private model and ramped it up into a public/private hybrid model to create a national clearinghouse for interbank payments.  You don’t hear much talk about this on a daily basis, but that’s really what the Fed is – it’s just a big clearinghouse to help smooth the payments system.  All the other stuff it gets attention for (like monetary policy) is just a sideshow to this primary purpose it’s serving – to maintain a healthy functioning payments system.

But the Fed is a weird entity when it comes to “ownership”.  It exists due to an act of Congress.  But it is also considered an independent entity because it is not part of the Executive or Legislative branches of government.   The Fed exists because Congress created it, but it doesn’t enact policy measures with any Congressional or Presidential approval.  Politically, this makes it a very independent entity.

The Regional Fed banks are arms of the Fed system that serve like regional versions of the NY Clearinghouse.   One thing that muddies this discussion on “ownership” is the issuance of stock by the regional Fed banks to the member banks.  This stock pays a fixed 6% dividend and gives the banks a claim on the Fed’s annual profits.   But let’s keep this in the right perspective.  Last year the Fed earned $90.5B.  Of this, $1.6B was paid out in dividends.  The remaining $88B was remitted back to the US Treasury.  While the US Treasury doesn’t technically own shares in the Federal Reserve the Fed is required to remit its profits at the end of the year back to the Federal Government.  As you can see, remittance often dwarfs any dividends paid back to the banks.  In other words, the US Treasury is the recipient of most of the Fed’s profits.

Let’s also not forget the primary purpose of the Fed.  Remember, the Fed exists to serve the payments system.  This means it is a supporter of the US banking system.  Before it can ever achieve its dual mandate on price stability and full employment the Fed must ensure the payments system is healthy.  Therefore, the Fed is often viewed as a servant to the banking system while also trying to be a public purpose servant.  It has, in effect, two masters by design.

The Federal Reserve system is an imperfect, but rather innovative clearinghouse.  Its structure as “independent within government” makes it hard to decipher precisely who owns it.  I prefer to think of the Fed as being an entity designed to help support the US payments system (which thereby makes it a bank facilitating entity) which serves public purpose and private purpose.  In other words, it’s better to think of the Fed as a public/private hybrid and not really being “owned” by anyone.

Sources:

Who Owns the Federal Reserve – Federal Reserve

Federal Reserve Annual Report – Federal Reserve

The Federal Reserve in the US Payments System – Federal Reserve

Debunking “The Biggest Scam In The History Of Mankind”

A reader forwarded this video on to me.  Apparently it’s gaining quite a bit of traction online.  The video is called “The Biggest Scam in the History of the World – Hidden Secrets of Money”.  Provocative, huh?  As you can likely guess, the video is about Federal Reserve conspiracy theories, the evils of fiat money and of course, how you can buy gold from the person who made the video.  The video is extremely well done, very convincing, provides lots of historical data and believable claims, but right off the bat I started to see some rather serious errors in the narrator’s claims.  Here are just a few from the first few minutes of the video.

In the first two minutes the narrator says:

“The modern banking system creates currency far faster than trees can grow”

I’m being a real stickler for details here, but technically the banking system doesn’t actually create the currency.  Banks create loans which create deposits.  The deposits can be drawn down to access paper currency, but that paper currency is actually created by the US Treasury who processes orders for it from the Fed system so they can supply it to the US banking system when bank customers need it.  You can read about the specifics of this process here.

Moments later he says:

“Treasury bonds are our national debt”

Right.  But the national debt is also part of the private sector’s savings.  If your grandmother owns a T-bond then the government has a liability and your grandmother has an asset.  When discussing a credit based monetary system it’s best to understand both sides of the ledger.  Otherwise, you’re missing half the picture.  A credit based monetary system can be extremely unstable at times, but just looking at debt levels won’t tell you much about that.  There’s much more to the accounting here.

Seconds later, he describes deficit spending as such:

“[deficit spending] Steals prosperity out of the future so it can spend it today”

The US government has run budget deficits for the majority of its history.  Just to put this in perspective, can you imagine what someone like this narrator would have said back in 1945 when the deficit was over 25% of GDP?  Do you remember how the government “stole” all of our prosperity back in the 1940′s?  Or did the USA undergo a massive economic boom over the 70 year period since then during which it became, by far, the most prosperous and wealthy nation mankind has EVER seen?  A little common sense should make you question the claim that government spending (which has happened for hundreds of years during an extraordinary American wealth boom) necessarily steals future prosperity.  Yes, government spending can have negative ramifications and isn’t necessarily always good, but there’s a bit too much hyperbole in the claim that deficit spending “steals” future prosperity.  That’s just not true in all cases.  The extremely high deficit from 1945 should make that abundantly clear.

deficit

Next, he’s explaining QE and states:

“This process is where all paper currency comes from”

As I described above, this is wrong.  Paper currency doesn’t come from QE.  Paper currency is supplied to the US banking system when bank customers have demand for it.  This comes from the US Treasury and the Federal Reserve, but really has nothing to do with QE.  QE does result in more bank reserves in the system, but bank reserves and paper currency aren’t precisely the same thing.  For more on QE please see my primer.

Moments later he defines money in a very peculiar way so that it doesn’t include anything that doesn’t serve as a store of value.  According to his definition money is a store of value, medium of exchange, unit of account, portable, durable, divisible and fungible.  He then claims that gold fits this definition.  But gold doesn’t fit this definition!  First off, you can hardly use gold to buy anything in the real economy.  Try going into Wal-Mart with a bar of gold.  They’ll tell you to piss off.  Better yet, try transporting all your gold around with you where ever you go.  Gold doesn’t even fit his own definition.  In fact, it fails almost completely in money’s most important function – as a medium of exchange.

Of course, most of our dollars don’t serve as a good store of value.  In fact, holding paper currency or even bank deposits is a pretty dreadful way to try to maintain your purchasing power.  Does that mean bank deposits and paper currency are not money?  Of course not.

The video then goes into a money multiplier explanation claiming that banks lend out deposits and reserves.  Anyone who actually understands banking knows this is wrong.  Heck, even Fed employees have written about this in recent years as the crisis and QE has clearly proven that the money multiplier concept is totally false.

By this point you should see what’s going on here.  I didn’t watch the rest of the video because it only took 5 minutes to see a whole multitude of errors.  In essence, the video is just a sales pitch for gold and an anti government agenda.  If you’re into that kind of thing then fine, but you’re being misled so be careful listening to people with such an obvious political agenda….

NB – It’s also interesting to note that the creators of this video are ultimately selling you a product.  They’re selling you gold and silver as seen here on their website.  And they’re using fear to drive you into that product.  But look what they want from you.  After countless hours of video trashing fiat money they’re asking that you pay THEM with…US DOLLARS.  If this whole thing doesn’t set off a great big red flag for you then I don’t know what to say.  Good luck?

 

Can We Stop with the “Socialism” Nonsense Already?

I see an alarmingly high number of commentators and pundits referring to the USA as some sort of failed socialist state these days.  Obviously, the healthcare debate has much to do with that, but from a more macro perspective it’s really all about the broader government spending picture.  People seem to have this perception that the US government is firing money out of rocket launchers like never before.  But are we really a failing socialist state?  The data doesn’t seem to confirm that at all.

If we look at total government expenditures as a percentage of GDP we’re still in high historical territory.  The most recent level of 34.8% is almost as high as any previous peak.  Then again, the latest recession was worse than any recession in the post-war era so it’s not surprising that government spending kicked in as a result of automatic stabilizers and the recovery act (tax receipts fell as a result of decreased output so the deficit rose automatically – this isn’t “socialism” kicking in, it’s the simple math of how a budget deficit works in a recession).

socialism

 

But let’s put this in the right perspective.  The historical average government expenditures as a percentage of GDP is 32.3% over the last 50 years.  That’s 2.5% lower than today’s levels.  But keep in mind we’re coming off the historical high of 39% at a rapid pace.  In fact, it’s been the private sector that has increasingly picked up the slack during the last few years.  If anything, capitalism is winning again.  And if we were “socialist” in 2009 then we’re more than 4% less “socialist” than we used to be and quickly approaching our average “socialist” level of 32.3%.

socialism2

 

What’s even more interesting about this data is seeing it by Presidential history.  If we were to list the Presidents by how “socialist” they are according to their historical average level then the list would look like this:

MOST “SOCIALIST”

1.  Barack Obama (37%)

2.  GHW Bush (34.1%)

3.  Ronald Reagan (33.6%)

4.  GW Bush (32.6%)

5.  Bill Clinton (32.1%)

6.  Jimmy Carter (31.2%)

LEAST “SOCIALIST”

If we’re becoming a socialist state (which I don’t think we are) then some of the biggest contributors to that progression are the very people who are often placed on pedestals as the shining beacon of the “free market”.  In fact, out of the 4 Presidents who have presided over periods when the historical average was breached, 3 of them are Republicans.

Anyhow, I think we can all agree that 34.8%  vs 32.3% isn’t the equivalent of a socialist state veering out of control.  I don’t think any of the Presidents on this list have presided over anything remotely close to a socialist state.  And I think that when we put things in the proper perspective we can see that people are probably being a bit hyperbolic in the use of such terminology.

NB – Please feel free to use the comments section to leave your hyperbolic comments about how we are a failing socialist state.  

Inflation is NOT Necessarily a “Different Form of Default”

Warning – this is likely to be an extremely unpopular post with a lot of people.  I apologize in advance for any inconvenience this causes your political biases.  I also apologize for the snarkiness in this warning.    

Every time I point out that the US government is a contingent currency issuer that can’t “run out of money” the same inevitable response always pops up where someone says that insolvency is really no different than what inflation is because inflation is just a “different type of default”.  This can be very misleading.  Let me explain.

We reside in a credit based monetary system.  That means almost all of the money in our system exists as a result of a simple accounting relationship.  Let’s say you have a great idea for a new technology that you think everyone will love and you think this technology will improve living standards.  But you don’t have the funding to produce and market the new technology so you go to your local bank to take on a loan.  You have excellent credit and maybe even some collateral so the bank is happy to extend you some credit.  In doing so the bank creates a loan which creates a deposit for you to go out and spend.

What’s happened here?  The money supply has increased.  And so has your purchasing power.  And you use that purchasing power to go out and build your new technology and sell it.  Let’s assume that after a few years of this your technology is a big success, has made many lives better, improved productivity for others and increased the amount of other goods and services your labor hours can currently purchase.  In other words, society is better off because of your technology despite the increase in the money supply and the inevitable inflation that will likely accompany this.

The key is understanding the simple point that enhancements in productivity allow us to consume and produce more goods and service with the same number of labor hours!   Said differently, your living standard improves despite an increase in inflation.

The US economy over the last 100+ years is basically one big example of this relationship between credit, inflation and output.  Here are some long-term charts displaying what was essentially described above:

tcmd

CPI

rgdp

In a credit based monetary system credit IS money.  And the supply of credit will expand over time as the economy grows to support a larger credit base.  Yes, at times this system will inevitably become unstable because its participants will take on more credit than they can afford or make other irrational decisions that cause imbalances, but over the long-term the economy is basically one big credit creating productivity enhancing machine that pretty much ALWAYS has higher inflation, higher credit levels AND, most importantly, increased productivity and output.  So no, it’s not right to say that higher inflation is a “different form of default”.  Despite the decline in the purchasing power of the dollar over the last 100+ years we are all actually better off because our productivity allows us to purchase more goods and services with the same number of labor hours.  Inflation and insolvency are totally different animals with very different causes.  If we want to understand these things and how they impact our lives then we need to better understand the causes here.

So, next time someone says that inflation is just a different form of default tell them to explore the details a bit more.  They might be right in some cases (like the very rare hyperinflation), but odds are they’re misleading….

And please, read the following pieces before responding about hyperinflation or how the government’s inflation statistics are all lies (since those are the next inevitable retorts to a post like this):

What do the independent inflation gauges say?

Understanding the causes of hyperinflation

 

Understanding why Austrian Economics is Flawed

Austrian economics has been through quite a rollercoaster ride over the last 10 years as the housing bubble appeared to vindicate many of their views and then the economic recovery proved many of their dire predictions completely wrong.  I think Austrian Economics is deficient and Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.  Allow me to provide three core reasons why I believe this:

1)  Austrian economics is a political ideology that masquerades as an economic school of thought.  Like most of the economic schools in existence today, Austrian Economics is predicated on a political ideology.  Austrians tend to be vehemently anti-government and pro-market.  So they build a world view that conforms to the world they want and not the world we actually have.

We’ve seen this time and time again in the last 5 years during the recovery as the government picked up spending when the private sector cratered.  There is always an excuse within Austrian Economics that implicitly assumes government cannot spend dollars any better than a household.  This might be true in a general sense, but it is not always true.  For that implies that households and businesses always make rational decisions.  As if choosing to have our government spend money on wars and welfare is all that much different than households spending money on the next release of the tech gadget they probably don’t need or the McMansion they can’t afford.

Austrians aren’t the only offenders of this (see here).  We see it in Keynesian approaches, Market Monetarist approaches, Monetarist approaches and just about all of economics these days.  Economics is built primarily on a bunch of political agendas designed to look like a science.  Austrians (particularly the Rothbardians) are so vehemently against government involvement in the economy that they are among the very worst offenders of trying to pass an ideology off as a school of thought.  It results in a very unbalanced presentation of our reality.

2)  Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system.

The act of targeting interest rates and implementing monetary policy are very much secondary to this primary purpose and the powers of such policy, as presently constructed, are vastly overstated by most economists.  Yes, the central bank controls a component of the interest rate that helps determine the spread at which banks can lend, but the central bank does not determine the rate at which banks borrow to customers.  It merely influences the spread.  Overemphasizing the Fed’s “control” over interest rates misunderstands how banks actually create money and influence economic output.

The primary flaw in the Austrian view of the central bank has been most obvious since Quantitative Easing started in 2008.  Austrian economists came out at the time saying that the increase in reserves in the banking system was the equivalent of “money printing” and that this would “devalue the dollar”, crash T-bonds and cause hyperinflation.  It was standard operating procedure to see charts of the monetary base like this one followed by dire predictions of high inflation or hyperinflation.  Of course, none of this actually panned out.  The high inflation never came, the hyperinflation definitely never came, the T-bond collapse was a terrible call and the USD has remained extremely stable.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds based model that most other economists use.  So they assumed that more reserves would mean more “multiplication” of money and thus hyperinflation.   Of course, as I’ve explained numerous times here before, banks are never reserve constrained and do not make loans when they have more reserves.  Further, QE is a simple asset swap that changes the composition of private sector assets.  Referring to this as “money printing” is highly misleading (see here for more details).  Austrians got this wrong because, in an attempt to attack government, they have devised a government centric view of money creation that misunderstand the way money is created primarily by private competitive banks endogenously.

3)  Austrians misunderstand inflation.  Austrian economists actually change the definition of inflation to serve their own ideological needs.  In Austrian Economics inflation is not the standard economics concept of a rise in the price level.  Inflation in Austrian economics is just a rise in the amount of money.  This leads to all sorts of emotional commentary, the most common of which, is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).   But this misunderstands several concepts and misleads us in understanding how the monetary system works.

First of all, the private sector creates lots of “money like” instruments that are not technically included in the money supply but comprise the vast majority of private sector net worth.  I use a “scale of moneyness” to help better understand this concept so that we don’t place an undue specialness on the idea of “money” when trying to understand inflation.  Instead, I try to explain that spending is a function of income relative to desired saving.  And that saving is comprised not only of “money”, but money-like instruments like stocks, bonds, options, etc.  To completely understand how the economy is impacted by inflation we shouldn’t merely focus on narrow definitions of “money”, but should understand the aggregate economic balance sheet.  For instance, if you sell a stock at no gain and obtain cash you’re not necessarily more likely to spend than you were before because your net worth is the same.  Your income relative to desired saving is precisely the same as it was before.  This is basically what QE is.  It is a swap of one type of asset for another and doesn’t actually alter the net worth of the private sector.  Changing the moneyness of private assets does not necessarily mean there will be higher inflation!

But there is a more egregious and nefarious error in this “decline” of the dollar myth.  It completely misunderstands how living standards can rise even while the money supply rises.  In our credit based monetary system the money supply rises primarily when banks make loans which create deposits.  In a highly productive economic environment these loans are distributed by private competitive banks and provide the borrower with the capability to invest in a manner that actually enhances the living standards of society.  So, you borrow $100,000 from the bank, you invent and distribute the washing machine and suddenly we’re all better off because we no longer have to go to the river to wash clothes.  The technological advancement enhances our lives by giving us more time to consume and produce OTHER goods and services.  In other words, the money supply has technically increased, but we’re not worse off because of it.  We’re better off because of it!  What’s happened since 1913 in the USA is just one gigantic version of the washing machine example where our living standards have exploded through the roof in tandem with a rising level of credit and an innovation boom that human beings have never come close to experiencing in the past.

Austrians, in their fervor to demonize the fiat money system, make several errors here.  First, they assume the government controls the money supply (which they don’t).  It’s actually controlled primarily by private banks in a market system that Austrians should love.  Second, they move the goal posts on the definition of inflation to imply that inflation is always and everywhere a bad thing (which, it can be, but generally isn’t).

That really just scratches the surface on some of the flaws in Austrian Economics.  I think Austrians provide some good insights on the way the economy and money works, but these are glaring flaws in the school of thought that render it highly inadequate in helping us understand the world of money in a balanced and objective way.

See also: 

Understand the Modern Monetary System

Monetary Realism Recommended Reading

The VIX – It’s Not Really Much of a “Fear” Gauge

Every time the market starts to dip a little bit the media starts going on and on about the the Volatility Index which is widely reported as the “fear gauge”.  In case you’re not familiar with the Volatility Index (aka, the VIX), it’s the implied 30 day volatility of the S&P 500.  But there’s two sides to the volatility coin.  And the VIX doesn’t only represent the implied downside volatility, it just measures the implied volatility.

So, it’s not surprising to see this good bit of research from Tobias Levkovich about the VIX and its reliability as an indicators of future returns (via Business Insider):

“Looking back at volatility data reveals that there are much higher probabilities for market gains when the VIX is sitting between 10 and 15 than when it is in the 20-25 range,” wrote Citi’s Tobias Levkovich in his August chartbook. “Levels of 20-25 do not generate good probabilities of market gains.”

At the low 10-15 range, the 3-month, 6-month, and 12-month returns were positive 74.4%, 85.0%, and 87.9% of the time, respectively.

At the low 20-25 range, the 3-month, 6-month, and 12-month returns were positive 58.0%, 55.8%, and 60.5% of the time, respectively.”

In other words, the VIX doesn’t really tell you where the market is headed.  It just tells you that some irrational apes expect it to be volatile, which is a lot like relying on the variance of the sun rising to make your next trade decision….

On Leaving Banks out of Macro & the Myth of the Fed’s Archimedean Lever

I focus quite a bit on banks in my work.  My entire view of the economy and monetary system starts by understanding what is.  By understanding the institutions and entities that operate within the system and how they act in various ways to influence outcomes.  It’s kind of like understanding how the human body works.  If you want to understand what causes growth and even disease then it helps to start by understanding the system at the operational level.

Now, some economists don’t view this the same way.  For instance, Scott Sumner of Market Monetarist fame (who, I am pretty sure hates me after I asked a few questions on his site over the weekend), says we should “leave banks out of macro”.  To me, that’s like trying to understand the human body by leaving out the circulatory system.  I guess you don’t need to understand it, but it sure would help!

Anyhow, JP Koning, who is always very fair, thoughtful and insightful (you should read his blog, btw), says that Sumner’s not wrong to leave banks out of macro because his world view doesn’t require banks.  JP says:

“To Minskyites and Post Keynesians like Cullen, who put a lot of importance on the banking system and the financial instability that results from bank failures, this claim is blasphemous. But given the side of the field from which Sumner comes from, I think he makes a lot of sense. As Sumner points out in his comment, his main interest is monetary policy, and Sumnerian monetary policy boils down to exercising control over NGDP. Sumner usually explains the by reference to the medium of account role of money, and though I think his terminology is a bit buggy, I agree with him.* By wielding its control over base money, or what Sumner calls the medium of account, the Fed can push up the price level, and therefore NGDP, to whatever heights it wants to.”

(Well, I wouldn’t totally align myself with Minsky, but I certainly do have PKE influences and believe that Minsky’s Financial Instability Hypothesis is incredibly insightful.)

He goes on to say:

“This relates back to my previous post in which I made the analogy of a central bank’s power to Archimedes’s boast that he could move the world. Give a central banker a long enough lever and a fulcrum on which to place it, and he’ll move prices and therefore NGDP as high as he wishes.

Whether there is a banking system or not in the picture will interfere in no way with a central banker’s Archimedean lever.”

This is really the crux of the issue though.  The Central Bank in the USA does not have an Archimedean lever.  Or if it does, it certainly doesn’t use it regularly.  The assets the Fed can buy are actually fairly limited (basically government guaranteed assets).  The Fed is not a true money printer in the sense that some might think.  It’s mostly a big asset swapper.  So, when it implements QE it swaps existing private sector held assets with deposits (via non-bank QE + reserves for the bank who plays middleman) or a clean reserve for asset swap (via QE with bank).  There’s no direct change in private sector net worth after this policy is implemented (aside from side effects like the “wealth effect” if such a thing exists).

Now, if the Fed could go out and buy bags of dirt for $10 from anyone who wants them then that would be an Archimedean lever.  They could literally fire dollar bills as base money out the front door of the Fed in exchange for bags of dirt.  Of course, they can’t do that.  They have to work through influencing the inside money system (the banking system where money is created inside the private sector as opposed to money like cash which is created outside the private sector) in some way.  And no, the Fed can’t force depositors to withdraw cash.  That’s simply not how the current Fed system works (cash is ordered from reserve banks and printed up by the US Treasury when demand from depositors increases).

Now, one could argue that the Fed could exert unusual powers using the exigent circumstances clause in the Fed Act, but then we’re entering the realm of making “exigent” = “permanent”.  That doesn’t make much sense and it wouldn’t fly in Congress.  So I don’t see how it makes sense to remove banks.  We have a monetary system that is designed entirely around inside money.  The Fed only exists because it serves the needs of the inside money system.  In my opinion, those who want to remove banks from the system are getting it all backwards.  They think the Fed steers the monetary machine when the reality is that the inside money system steers the monetary machine and the Fed just acts as a facilitating entity.  The Fed is basically a big bank with unusual powers that supports a private competitive money system run by private banks.

Perhaps more importantly though, the Archimedean Lever is really a fiscal lever.  If the Fed could actually print cash and push it out the doors in exchange for bags of dirt then it would essentially be executing a form of fiscal policy by directly changing the financial net worth of the private sector (buying bags of dirt in exchange for cash would directly change private sector net worth by adding a net financial asset).  But the laws create a rather fine line here.  And as the laws currently define and as policy is currently executed, the Fed is left to policy that basically comes down to influencing prices by swapping assets and making loans.  I guess some might call that an Archimedean Lever, but it’s not the power of the purse.  That power rests with the US Congress and by extension, the US Treasury.  Eliminate the banking system from your model and you eliminate the need for the Fed (which exists to support the inside money system).  And that leaves you with an entity that executes the power of the purse (without a banking system the Fed and Treasury basically become the same entity serving the same master – the US Congress).  As it currently exists, the Fed does not execute such powers and must rely on its influence over the inside money system primarily.  In other words, if the Fed has an Archimedean Lever, it’s an inferior one to the one the US Congress and by extension, the US Treasury wields.

What Is the Biggest Mistake When Evaluating a Fund?

There was a good piece in the WSJ about fund selection yesterday.  They interviewed some great advisors.   The answers were mostly the same – watch past performance, watch fees.  What surprised me was that no one mentioned the problem of benchmarking.   This is, in my opinion, the biggest problem in the fund world.

What’s happened over the last 30 years is that we’ve created a mass of various fund styles that don’t really do anything that much different than an index fund.  For instance, most “large crap growth or value” funds are really just closet S&P 500 funds.  If you ran the risk adjusted returns on these funds you’d notice that the correlations are extremely high in 95% of the cases and that they’re basically just fee sucking closet index funds.  They add literally negative value to your portfolio when compared with the low fee option.

I audit a lot of funds these days when I perform reviews for people.  And the benchmarking issue is the one that always comes up as being the most problematic when trying to justify whether a client should own a fund.  The fund is either benchmarked incorrectly or it doesn’t perform well relative to a highly correlated index.  To me, that’s the biggest problem when evaluating a fund.

Not only should we be ensuring that we’re benchmarking the funds properly (because the fund rating companies don’t always do it properly), but we should be ensuring that the funds we’re picking are actually a good value relative to the benchmark.  That requires some risk adjusted return calculations and some modestly sophisticated understanding.  But it’s no excuse for lazily looking at past performance, fees or other problem areas.  The devil is in the detail in most funds.  And sadly, when we look close, most of them are worse than their star rating states….

Does Past Performance Matter?

Here’s a good paper on the mutual fund industry from S&P.  It shows more interesting evidence that the mutual fund world is, for the most part, a world of closet indexers charging excessive fees for something that they can’t deliver (via S&P):

- Very few funds can consistently stay at the top. Out of 703 funds that were in the top quartile as of
March 2011, only 4.69% managed to stay in the top quartile over three consecutive 12-month periods at
the end of March 2013. Further, 3.35% of the large-cap funds and 6.08% of the small-cap funds remain
in the top quartile. It is worth noting that no mid-cap funds managed to remain in the top quartile.

-  For the three years ended March 2013, 16.57% of large-cap funds, 14.22% of mid-cap funds and
23.05% of small-cap funds maintained a top-half ranking over three consecutive 12-month periods.
Random expectations would suggest a rate of 25%.

-  Looking at longer-term performance, only 2.41% of large-cap funds, 3.21% of mid-cap funds and 4.65%
of small-cap funds maintained a top-half performance over five consecutive 12-month periods. Random
expectations would suggest a repeat rate of 6.25%.

-  While top-quartile and top-half repeat rates have been at or below the levels one expects based on
chance, there is consistency in the death rate of bottom-quartile funds. Across all market cap categories
and all periods studied, fourth-quartile funds had a much higher rate of being merged and liquidated.