Q&A – The Answers

Thanks for another Q&A session.  You guys asked some really important questions.  The most important one of which was:

“Who put the bomp in the bomp bah bomp bah bomp?”

I think it’s more important to know who put the ram in the ramma lamma ding dong, but that’s just my personal opinion.  Anyhow, the answer is obviously the man who made a woman fall in love with Barry Mann.

Now that the important stuff is out of the way, we can move on to other less serious matters.

WGO:  Have you ever shorted treasuries (and not as a bond vigilante but as a trade)?

CR:  I wouldn’t call them bond vigilantes.  They’re more like bond vultures because they basically just front-run the Fed and scavenge off the communications and outlook from the Fed.   They don’t attack the US economy and push the US govt around.  And yes, I have been very short US Govt bonds.  The most aggressively short I have probably ever been was back in 2009 when I said it was going to be the “trade of the year.

WGO:  Are you surprised that equities have rallied while gold and commodities have sold off with QE3/QE4 announcements? Also why don’t you poke fun at the many gold bugs who promised the dollar would roll over and gold would surely rally after QEn?

CR:  I thought I was too hard on the gold bugs and hyperinflationists?  Maybe not.  Anyhow, I don’t view commodities as an investment class and I think it’s unfortunate that Wall Street has jumped on the recent rally in some commodities to sell this asset class as though it’s an essential piece of a portfolio.  The long-term real returns from commodities is horrible.  Gold is a bit different because it has a currency component, but it’s still also a commodity.  I build portfolios using an understanding of what I refer to as a “hierarchy of assets” and understanding how economic growth and certain environments contribute to asset class returns.  Gold is not high in the hierarchy because its currency component embeds a put in the price that is largely faith based.  This means there is no way gold can serve as sufficient protection against permanent loss.  That, in my opinion, means it’s reckless to build a portfolio that has a very heavy weighting in gold.

WGO: What do you see as the biggest risk for the markets going forward?

CR:  The biggest risk is still Europe.  I don’t think the Euro crisis is resolved.  Civilian unrest could cause a serious disruption in the global economy.

WGO:  Who is the most annoying poster on your site (note I try really hard but I’m not sure I’ve convinced you just yet)?

CR:   Honestly, readers are really well behaved here.  I had to ban a few MMT people because they were unbearable (literally the only group of people who have driven me to insults on the site), but that was really unusual.  There are a few hyperinflationists who roam the comments on occasion, but on the whole they’re very civil.  I think most readers know I don’t like to ban people and I don’t like to engage in childish banter so there seems to be a certain level of understanding here that isn’t present everywhere on the internet.  After all, I am just another guy trying to find answers to big big puzzles.  I’m not here to fight and argue with people even if some commentary gets contentious.  I like to say, we’re challenging other people’s ideas, not attacking other people…..That’s how I approach it and I think most of the readers here do as well.  I appreciate it enormously…..It’s a nice change of pace from many comment sections on the web.

Geoff:  How did the USA become the greatest hockey nation in the world? Congrats on the big win today.

CR:  Seems to have started in the late 80’s when I started playing hockey.  It was smooth sailing ever since then.

Undergrad:  In an economy with a large amount of private sector debt, like Japan or the US, is there a relationship between falling asset prices and collateral values that creates a shortage of dollars, thus putting deflationary pressures on an economy?

CR:  This is, in large part, what the balance sheet recession is all about.  Asset prices fall while debt levels remain the same causing defaults.  This can be catastrophic in an economy as you can see in Japan.  Luckily, I say the USA is “Japan on fast forward” and didn’t suffer the twin bubbles in real estate and stocks.

Tom asked about corruption and abuse in the financial space and why he shouldn’t be enraged by it.  

CR:  I think you should be enraged by this.  The US monetary system is designed so banks “rule the monetary roost”.  The US govt outsources the creation of money to these private entities in a market based system that is in keeping with capitalism.  Banks compete to issue loans.  But the private profit seeking nature of banking combined with money creation generates a bit of a conflict where banks can be incentivized to take excessive risk in order to create more profit.  Banks are the lifeblood of our monetary system since they’re the payment system in essence.  If the banks seize up the system seizes up and the govt has to ride into the rescue through taxpayer bailouts.  I think this extraordinary money creating process requires extraordinary oversight since the banks issue our money which is OUR social construct.  Simple rules can be implemented to help banks better manage risks since they’ve proven they can’t manage risks on their own.

Will said I need to debunk another sites’ content.  That’s for a full post though.  

Cowpoke:  Now that ya mentioned it, Where can I find the best fish taco in San Diego?

CR:  There is a little place in Pacific Beach called “The Pacific Beach Fish Shop”.  If you go there ask for a fried albacore taco, a lobster taco and a TKO Taco.  You’ll put on a few pounds, but that’s necessary this time of year anyhow.

William:  I want to know why there are always really hot women on those “Google banned this video” ads I see on your site from time to time, and if you have actually seen the banned videos in question.

CR:  I have never watched a video of a scantily clad woman on the internet in my entire life so I have no idea what you’re talking about.

Scott K:  I want to know how is that as soon as I moved from MD to upstate NY the Redskins acquired RG3 and they are now a team to root for? Waah.

CR:  Give them some time.  The Redskins will screw all of this good stuff up somehow.

MG:  Are you a California liberal who wants gun control?

CR:   I’m a pretty centrist guy who tends to vote socially liberal and fiscally conservative.  I grew up shooting guns in West Virginia and back home in VA/DC so I am not an anti-gun person.  I am also no gun expert, but I do wonder why anyone would ever need some of these automatic weapons that hold 30-100 round mags.  I just don’t understand that.  The only thing you can do with a gun like that is wreak havoc on things. But I also know that banning certain semi-automatic weapons isn’t going to end the gun murders in America.  Anyone who understands guns knows that you can unload 30 rounds in a couple of Glocks in less than a minute.  I think there are a lot of problems with the gun culture in the USA.  And I am not well versed in all of those areas to decide what the right fix to the problem is.  But clearly, there is a problem.

Cowpoke asked a question about the Iraqi stock exchange that was either a joke or something I am definitely ignorant about.  

Curious88:  Are you familiar with any period in U.S. or other country economic history that is similar in terms of economic and market performance to what we are living through today? If so, what are the investing lessons that we can learn from that period?

CR:  I think Japan and the Great Depression are the only two similar periods, but even those aren’t the same.  As I like to say, the markets and economy are complex dynamical systems.  The future never rhymes perfectly with the past because each occurrence is its own unique event.  I think the biggest lesson from this recent economic environment is understanding how important it is to learn how the monetary system really works.  The people who have misunderstood the big picture have made huge calculated errors based on misunderstandings.

Michael:  Does MR hold that the base case for the national deficit is about equal to the balance of trade deficit? Seems to me the projected deficits are a little weak once that is factored out. Good luck with the romance novels,is there no limit to your talents?

CR:  MR doesn’t really say what the deficit should be.  Rather, we just describe the relationship between the different sectors of the economy.  The key to understanding the sectoral balances and the relationship to the foreign sector is understanding that, with a weak private sector investment, a govt deficit that’s smaller than the current account deficit will almost certainly lead to economic contraction.   That’s just an understanding.  It’s not really an MR opinion as much as it’s a matter of accounting.

WTR:  If gold is a commodity then the dollar is a commodity………..correct?

CR:  Depends on your definition of “commodity”. http://www.merriam-webster.com/dictionary/commodity

Ray:  Do you think the Japanese central bank will be successful setting a target inflation rate of 2%, there seems strong polticial will now to seriously reflate? Also the recent Fed minutes indicate the possibility that they may stop bond purchases in 2013 i.e. growing number of disenters, do you think this would be quite negative for bond prices and eventually for equities?

CR:  They won’t be successful by implementing more and more QE.  Personally, I think Japan’s long battle with their own balance sheet recession is coming to an end so I think they might begin seeing higher inflation in the coming years.  But not because of what the BOJ did….And the Fed will remain accommodative well into 2014.  I don’t think we have to worry about them stepping on the brakes any time soon.

WTR:  People keep on arguing with me that the government forced banks to provide mortgages to people during the period 2000 – 2008. The banks accepted this coercion because the government agreed to cover any losses the banks might incur. What is your view on this point…?

CR:  Lots of blame to go around there.  Homeowners wanted to speculate, the govt wanted us to own more homes, the banks wanted to make more profit.  The conspiracies start getting muddle when people start claiming that the banks or the govt were the only one’s to blame.  I think there were many contributing factors.

Tim:  If the U.S. Debt continues to grow at more than 1 trillion per year for at least the next 10 years with no meaningful year over year aggregate inflation, then what, if any, concerns would you have for the sustainability of the U.S. Economy?

CR:  If anything, this would be consistent with a stagnant move in living standards and a huge decline in US competitiveness.  I think there are already signs this is occurring.  But I think the USA is a much more resilient economy than most are giving it credit for.  My guess has always been that the balance sheet recession would end by 2014 so if we’re running trillion dollar deficits next year you’re going to start seeing some inflation…..

Denny:  2 questions:

1) Why would a bank prefer to swap Tbonds for reserves( hold more reserves)? Is it because they expect an increase in customers demand for cash/loans?

2) Do you own a piggy bank? I’ve always wonder what investment managers do with their pennies.

CR:  1)  Remember, monetary policy is about being part of the club.  If the banks want to be a part of the Primary Dealer club then they have to make a market for the Fed.  That’s just part of the deal.  It’s not about wanting to or not wanting to.  If the Fed tells JP Morgan to jump, Jamie Dimon says “how high?”

2)   I keep a small bowl of coins around, but I don’t hang on to coins for the most part.  I hate physical money.  I’ve banked online for 10 years.  I don’t even know where my bank is or if it exists.  To me, physical money is a thing of the past.  Something that’s dying a slow death.

WTR:  You promote the macro view, which I agree is essential today and in to the future. To me macro means global. What does it mean to you, since you seem to be US centric……………..? America is no longer independent of what happens elsewhere in the world.

CR: Yes, macro is definitely global.  In fact, half of my clients in Orcam are foreigners.  I focus primarily on the USA, but that’s only because that’s the monetary system I am most familiar with and the one that generates most of the global output.  But I don’t totally ignore foreign economies and markets.  In fact, over 25% of my personal assets are invested outside of the USA…..To me, macro is about understanding the big picture so you’d have to start with a world view and break it down piece by piece into the micro.

Scott K:  Why didn’t the Redskins put in Cousins for RD3 tonight when it was clear he was hurt?

CR:  Beats me.  The kid wanted to play, but it was pretty obvious that his knee was wrecked.  Frankly, I am not that upset that we lost and he went down.  This way there’s no chance he can do more damage to the knee this year.

JP asked about the govt spending constraint.  

CR:  It’s important to understand what govt spending is in the first place.  Most people don’t get this right.  When the govt taxes it takes from Peter to pay Paul.  When the govt spends in excessive of tax receipts it must sell bonds to finance the spending.  So, they sell a bond to Peter to pay Paul AND issue Paul a bond.  So, the deficit spending results in a redistribution of existing money AND the issuance of a net financial asset (the bond).  So, govt spending is really just a perpetual redistribution mechanism.  It’s not really money printing as most people call it (unless you want to call bonds money which is not correct).  The govt sells the bonds basically by bribing the banks to be their dealers.  So the govt doesn’t “run out of” buyers.  Auctions are literally designed not to fail.  But all this spending can cause inflation.  And the issuance of net financial assets can cause healthier private balance sheets to leverage up by borrowing from banks (who are the real money printers).  This whole process can cause inflation which is the real constraint.  Spending in excess of productive capacity could cause the economy to overheat and could cause any number of problems from asset bubbles to real declines in living standards.  So always remember that high inflation is the constraint.



Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. The gun violence questions are really complex and – like most things – highly politicized and partisan. One reason I really took to PragCap is because of the inherent “da Vinci approach” of trying to first understand “what is.”

    Also worth noting is that actual legally manufactured “automatic weapons” are pretty rare, difficult to acquire and extremely expensive relative to most firearms.

    I’ve done a lot of research lately on the topic of firearm and violent crime and can point to a number of primary sources if you ever want to get a better picture. Unfortunately, it’s probably a lot more challenging and nebulous than monetary systems.

    I’ve also seen the topic “blow up” the comments section at Ritholz’s site, to I might suggest keeping a tight rein on it here or skipping the subject altogether.

  2. You say, ”so if we’re running trillion dollar deficits next year you’re going to start seeing some inflation…..”

    That feels like a concession that deficits will cause inflation. And considering that present deficits are primarily structural (more entitlement spending for growing numbers of non-working people), it seems like something we should get ready for as investors.

  3. “Gold is not high in the hierarchy because its currency component embeds a put in the price that is largely faith based. This means there is no way gold can serve as sufficient protection against permanent loss.”

    It’s rather disconcerting that a smart guy like Cullen can be so outrageously wrong about gold. To say that gold cannot protect against permanent loss really just makes me scratch my head…

    Disclaimer: I am not a gold bug, and I am not an advocate of a gold-linked currency. I am just comfortable admitting that gold has intrinsic value.

  4. Surveys show most members of the NRA are not in agreement with its extreme leaders on blocking any type of control. But powerful lobbying rules all.

  5. My reasoning is rather simple. There’s a huge put embedded in the price of gold due to its currency component. See gold’s returns compared to most other commodities in real terms. There’s a faith component in there that’s dependent entirely on a belief as opposed to something fundamental. I don’t think you should design portfolios around something like that, but that’s just me….

  6. I’ve never said deficit spending couldn’t create inflation. Johnny, honestly, I have to ask you again – do you even read the website?


    how much gold depends on how much money in other form you have. If you have savings worth 100 years of good living you should put 25 years in gold because quite simply you don’t need that money now and in the future, but you must be 100% sure you will not loose the remainig 75. If you have savings worth just 5 years the quantity of gold should be zero because you don’t have money to buy any kind of insurance and must rely on something else. Is up to you what in between.

    I believe this is the reason why central banks still have tons of gold and why the FED is still the largest single owner of gold in this planet: big player = big insurance

  8. That’s not usually how insurance works. Most insurance is much more leveraged than that. For instance, a simple term life insurance contract usually leverages 2-5% of face value over the course of the contract to meet some potential payout. It’s insurance because it’s just insuring something more central to your overall plan. Personally, I don’t think you should be using 25% of your portfolio to insure against it. But that’s just me. Your insurance agent might disagree! :-)

  9. This is the first instance in your posts in which you’ve predicted inflation if current deficit spending continues … without qualifying that statement.
    Previously, and on the website, you’ve said inflation is not likely if only when deficit spending outstrips productive capacity. You’ve also said deficit spending is OK if the rest of the economy is not picking up the slack.
    I think we’re entering a period in which large parts of the public have demands but not the means to purchase the plentiful capacity available. What good is capacity if there is no demand backed by money?

  10. Cullen,

    Thanks for your response but I gotta ask why an investment bank would want to be in Primary Dealer club?

  11. The Primary Dealers earn commissions and get information from the Fed. It’s a good club to be in. If you manage your stock of bonds correctly, it’s a free lunch.

  12. Most people who favor abortion oppose partial birth abortion but all attempts to ban it have gone down in flames.

    18,000 babies die in PB abortions in the US each year. It’s unlikely that any of these cases involve “the health of the mother” and if the pregnancy is the result of rape or incest it definitely could have been stopped earlier.

  13. That is a fair analysis. However, I think making the claim that a) gold derives its value due to its monetary history, which is more of a faith based/human behavioral type of quality rather than an investment based fundamental quality — is quite different than making the claim that b) by owning gold you risk permanent loss of value.

    These are two different claims; one is credible, the other not so much (in my humble opinion).

    When you claim that the value of gold can simply vanish, you ignore the entire history of human civilization, which is something I’m not willing to ignore.

  14. “… but I do wonder why anyone would ever need some of these automatic weapons that hold 30-100 round mags. I just don’t understand that.”

    I also surmise that you don’t understand driving a car on the street that will do 150mph+, or jumping out of a perfectly good airplane with a few pounds of nylon strapped to your back, or even renting an actual full automatic machine gun with a 50 shot clip once for a “cheap thrill” at some Las Vegas gun shops.

  15. of course this thread is just for playing so let’s play a little more. What insurance ? Clearly in case the current monetary system goes broke in case of a gigantic Lehman 2 or the aliens land on this planet etc.. Gold is the ONLY one kind of money that is out of the banking system and is accepted in exchange for food or energy in any angle of the planet. If tomorrow Adolf Hitler born again in Kansas is good having some of your money in a vault in Swiss or Singapore. So you cannot leverage this stuff. If I have to protect my savings for inflation well I know where to put my money and is not gold or 99% of the equity market.

  16. Cullen,

    The following may be a little off topic from this Q&A article, but it is a topic that has been addressed multiple times here over the last 3-4 years……namely, that you have argued the fed’s QE activity has no impact beyond interest rate suppression because the reserves created aren’t available to the primary dealer banks to do anything with……I and others have argued the opposite…..that the fed wouldn’t pursue a policy that would harm banks it is trying to help (extract potential interest income), and the inflated prices of speculative equity and commodity markets seems to confirm Bernanke’s stated intention of his policy “to elevate prices to higher levels than they otherwise would be”.

    I, and maybe others, haven’t known enough about the mechanics to counter your argument that PD use of the reserves isn’t possible…….but this article from Zero Hedge seems to describe the process, through “repo” and/or “rehypothecation” of the reserves, and/or some other means by which the banks CAN speculate with reserves provided by the fed. Can you comment, or show how this article is wrong about use of reserves? Thanks, krb

    Dear Steve Liesman: Here Is How The US Financial System Really Works
    Submitted by Tyler Durden on 01/07/2013 – 16:45

  17. The deposit-loan gap could be just due to the loans being transformed into securities (e.g. MBS). Perhaps the banks wanted to up their capital ratios and spin-off their loan books into something where there was an extremely willing buyer (again, e.g. MBS). Otherwise, ZH didn’t provide a specific mechanism for an alternative explanation … I don’t see why JPM, with it’s *massive* balance sheet wouldn’t have $300B in securities ‘to play with’. Also, lending to sovereigns (i.e. buying Tsys) usually happens in crisis because they’re getting great spread with no charge to Tier 1 capital; they would rather buy Tsys than make new risky loans which require capital.

  18. krb – I saw that article on ZH as well and did some research. Modern Money Mechanics, put out by the Fed, does indeed say you can excess reserves for loans OR investments. So is “Tyler” correct or am I missing something Cullen?

  19. Investing (saving) on fundamentals is also faith based, surely you can see that………..

    It doesn’t matter what people did with gold in the past. It only matters that people value gold as a store of wealth in the future………

  20. DANG IT Cullen..”a fried albacore taco, a lobster taco and a TKO Taco.”
    Now ya got me Jones’n . What When Where or HOW can I make these on my own, seeings as I am 1600 Mileas away.. Dag nabit@!!@#$#@!!!

    I have been thinking more about these Damn Tacos than I have monetary policy since you posted this..