Q&A – THE ANSWERS…

Thanks again for all the great questions.  They seem to be getting more and more challenging which I don’t like.  Maybe next week you guys can throw me a few lobs?  Okay, just kidding.  I’ll do my best to answer each one below:

IM:  What do you think of the idea of non debt based money and the central bank conducting monetary policy directly with the people instead of through a handful of financial institutions?

CR:  This is an interesting subject and one I unfortunately don’t have a great answer for.  Ideally, banks would serve public purpose and function purely as the grease in the engine of capitalism.  The reality is that they are private profit seeking entities that don’t align their interests with public purpose and so often conflict with it.  Banks are very necessary parts of this system and are a core piece of the payments system and the economy in general.  We could theoretically nationalize the banking system (a system some MMTers support and one I have said is the most logical MMT construct – see here for MMR comments on this), but then lending would be highly politicized and disconnected from the profit seeking motive that often keeps it under some constraint.  Personally, I am in favor of better regulations, not a nationalized banking system.  But neither are in the immediate future so get used to the current construct and the likelihood of more volatility in the credit cycle in future decades.

Replica:  Is it possible that a private bank that is neither capital constrained nor reserve constrained creates credit money and uses that to buy a bond? The loan creates a deposit in the banking system, but no new reserves would be created right away. Or does the bond sale always involve a reserve drain somehow?

CR:  Bond auctions settle with current reserves or reserves supplied by the Fed.  You might review this article for more on this process.

Eurocrat:  You often write about how loans create deposits, with the deposit being created “out of thin air”. Does this also apply to bond purchases? For example, if a Spanish bank buys a Spanish government bond, does it create money to do so (i.e. does the bond create a deposit)? And if so, what is the limit to this?

CR:  When I refer to how loans create deposits I am referring to private credit creation.  As a currency user, the Spanish government is like a state in the USA so when it sells bonds to then spend they are just borrowing from other private sector investors.  The process of loans creating deposits refers to the creation of private credit and the fact that banks don’t lend their reserves.  Rather, banks lend first and find reserves later.

Ryan:  What would Greece, Spain, Italy, etc. look like if they exited the Euro? Is there more economic damage through continued austerity or by exiting the Euro?

CR:  We know what would happen to some degree if they exited.  Their new currencies would crater and they’d become substantially more competitive with their neighbors.  This would also likely trigger a massive banking crisis as mass defections would cause defaults which would ripple through the banking system.  It wouldn’t be all that dissimilar to what happened in Iceland.  It would be a crushing blow to the economy in the immediate term, but would certainly be the start of a long-term healing process as it would restore autonomous currency issuing states.  I see the likelihood of this as very low though.  These nations benefit from the Euro and the more rational way to become sovereign in their own currency is for Europe to unite and finalize the currency union through greater political unity and some form of central treasury.  Unfortunately though, there is no real fix in the immediate future so the sustained depression in Europe continues…..

Exertia:  Cullen, I’ve been a follower of this blog since a couple of years now and have always valued your insight into the markets and your generally accurate market calls and predictions.

This year’s short call though, when the S&P was at about 1300 has left me (and I think most of your readers) stumped. Has this been your worst call to date? Are you still sticking with the short call? What would make you call it off?

CR:  I do not ever recommend that readers attempt to mimic my moves mentioned in the algo signals.  Not only is it just one strategy of many that I implement, but it’s rather complex and precise in its implementation.  Your comment shows how great the confusion on this can be if you don’t fully understand how I am implementing the strategy.   The algo kicked off a short signal at 1325 on 1/25, but the strategy essentially dollar cost averages into the trade over a sequence of trades.  I explained this process here.   So the trade actually resulted in a sequence of shorts at S&P 1325, 1350 and 1400 (roughly).  It then triggered a cover signal into the big move down on 4/10 (the day the market bottomed) resulting in an absolute return of ~3% (it doesn’t trade the S&P), but a relative loss of  ~3% since the S&P outperformed the strategy over this period.  This shows the power of position sizing.  I shorted into a 7% move and managed to generate an absolute return on the trade.   If you haven’t read this piece on position sizing I would highly recommend it.   The search results on the site also have some good stuff on money management and position sizing.  Highly recommended.

DAC:  I have been an avid supporter for a few years now and try to explain my basic understanding of MMR to others, esp financial/investment people. No one seems to disagree with the logic for a currency issuer but their gut feel is that the markets would punish any government which converted to MMR. How would you see the transition working? Also as every currency needs to be competitive in this world of global trade and capital movement, aren’t their FX constraints in operating MMR? If a government did the right thing, focusing on keeping the economy growing rather than feeling debt constrained, there could be an ill-informed market backlash for some time causing chaos for businesses and jobs?

CR:  The true constraint for an autonomous currency issuer is inflation.  This is a powerful insight since it eliminates the fear of default (which is totally misguided and results in flawed conclusions regarding policy).  I think this understanding would result in a more streamlined process if implemented correctly.  Obviously, once politicians understand that they have a bottomless money pit, they’d have to be constrained.  So the goal then is to create a process whereby we can measure the effectiveness of spending and its impact on inflation and living standards.  I would do this by running all new spending through a CBO analysis so we can understand its impact on inflation and living standards.  I think, if implemented correctly, we could actually make govt spending MORE efficient and in-line with our goals as a society.

Bear asked a series of questions on the LTRO and Europe, but the organization of the questions were a bit garbled so here’s my broad answer:

The LTRO allows the private banks to borrow from the ECB and buy sovereign debt.  This helps keep demand for bonds high and rates low.  But it’s got ponzi aspects to it in that it is potentially filling the banks with even more debt that is not risk free (because the issuer is not the currency issuer).  But since there is austerity being imposed it is only “money printing” in that it’s not resulting in the deflation that would result from the alternative scenario.

Anti asked a series of questions about my investment approach.  I explain my multi-strategy approach here.  

Brazzo:  Every time we had interest rates very low for very long a bubble was created in some asset class. MMR says inflation will not be a problem and you believe we will muddle through. Do you see any risk of a bubble and if so in what market?

CR:  I see no reason why current policy won’t eventually result in another massive market dislocation.  Between the Fed’s misunderstanding of QE, ZIRP, the obsession with our solvency and the ineffectiveness of our government’s spending approach we seem to have many of our priorities backwards.  We have been intent on propping up markets and banks when we should have been more worried about the real economy and households.  We’ve changed almost nothing about the system and what caused 2008 so I see no reason to expect a different future result.   I wouldn’t say we’re at the stage directly preceding a bubble and a collapse, but I have no doubt that we’ll get there again in many markets in the coming decades.  It’s only a matter of time given the structure of the system.

Delta:  I do want to push you further on the interest rates part of it, though. The way I see the world from 2003-2007 is this: extremely high commodity price inflation. Moderate CPI caused primarily by a surging share of Chinese imports – lower prices on imported good led by the peg and increased Chinese efficiency. That led to skewed artificially low interest rates which were a big part of a generalized asset price bubble. Consequent rise of overall debt and a vast increase in CA deficits because the incentive structure was falsely encouraging the choice of consumption over savings. That to me is where a lot of the imbalances came from. I’d love to have you poke holes into that argument.

CR:  I think this subject is far too complex to pin on any single cause (like low interest rates).   For instance, the trade imbalances and crisis in Europe are due to the flawed currency system.   So that’s a unique case study all on its own.  Current accounts are certainly worrisome and I’ve explained why in this piece (see section 3).  I don’t think it’s any secret that govt policy in many countries has promoted consumption over production.  So I don’t even disagree with your comment really, but I do think this matter is far too complex to blame on any single cause.  Sorry for the vague comment, but this is a VERY broad subject…..

whatsgoinon:  What tail risks do you fear/see in the economic landscape and if you are allowed to say how do you hedge yourself for them?

CR:  I’ve long been predicting that the USA would NOT enter a recession in 2012.   And my work on the balance sheet recession leads me to believe that we are Japan on fast forward and that the US economy is healing much faster than many presume.  So we’re climbing out of this hole, but the great risk is that just as we’re getting out of the hole the government will kick into austerity mode and kick us right back in the hole.  So the big risk in 2013/14 is that the government ratchets back spending big time and turns healing into pain.  This is not only the big risk to the broader economy, but also to corporate profits.  So it’s all eyes on government spending in my opinion….

Johnny Evers:  What are your thoughts on Ray Dalio’s template of the ‘Economic Machine’?

CR:  I answered this same question last week.  Here’s the answer:  CR: Dalio’s a genius and I often cite him here. We both often describe the monetary system as a machine. This is a really useful way to think of the monetary system because, it is, after all, a system. And this system has many moving parts that all come together to achieve some particular outcome. If you don’t understand how all the pieces of the system work then you can’t be expected to understand how it will operate in certain environments. I think Dalio does a better job than just about anyone doing this, but in my humble opinion, he does misinterpret the way an autonomous currency issuer functions in this system. We’ve heard him discuss the problem of the national debt and a potential insolvency in the USA so it’s clear he’s not approaching the view of the machine in the same manner that I am. This is not surprising given the fact that MMR is a far from a mainstream perspective…..

Armo Trader:  Would you fuse the Fed & Treasury together given how closely they work with each other? This would mean getting rid of any private part of the Fed, and just having appointed officials working in the “Fed” part of the Department of the Treasury.

CR:  I wrote about this briefly on Friday.  Personally, I don’t think we NEED to fuse Fed and Treasury.  We just need to better understand that they’re two pockets in the same pair of pants and that the conspiracy theories about the Fed being this evil blood sucking entity are largely bunk.  Then we can get over the hysteria about the Fed colluding with banks and better understand how our monetary system actually operates.  After all, we can’t expect to optimize the machine’s output if we believe in this myths about Fed independence and how they’re just colluding with the banks to wreck all of our lives….

WOJ:  Speaking either for yourself or MMR (or both), how would you define austerity? Are there specific measures involved or is it simply a policy goal?

CR:  To me, austerity is an insufficient budget deficit.  That depends on specifics in each nation, but in the USA for instance, austerity might involve a budget deficit that is not in excess of the current account deficit.  That would result in a net drag on the country.  We’re not imposing austerity in the USA though.

Perpetual Neophyte:  2008 seemed to primarily be a banking liquidity crisis. TARP took care of making sure there was liquidity for the banking system and re-capitalized them.

2010 and 2011 seemed to primarily be an EMU state sovereign liquidity crisis. LTRO took care of making sure there was liquidity for the EMU banking system which they have used to re-capitalize themselves with the LTRO/sovereign carry trade. This indirectly provided liquidity to the EMU state sovereign bond system.

If EMU bank capitalization is reduced by falling sovereign bond prices, and bank lending is capital constrained, does this increase the likelihood of another major round of EMU state sovereign yield increases? Or, would another round of LTRO continue to “yank the leash” on EMU state sovereign yields?

CR:  There are a few important points here.  First, I don’t think the USA had a banking crisis.  We had a household debt crisis.  The banking crisis was a symptom of this.  One of the more prescient things I ever wrote here were these comments from 2008:

“We have a major capital problem at the U.S. banking level.  What Ben Bernanke and Hank Paulson are essentially proposing is an asset swap.  The Fed will take on the toxic assets of the banks and they will receive reserves in exchange.  This is important because it will alleviate the strains in the credit markets.  That’s a good first step, however, it is not a solution to the problem at the household level and THAT is where the real economic weakness is.  By introducing this asset swap idea Ben Bernanke is simply altering bank balance sheets.  He is not fixing the economy.

So, the government has a partially correct solution. Not the BEST solution, but it gets to the core of the credit issues. They will essentially trade the bad paper for good paper and it will alleviate many of the pressures on the banks. As I have written here many times the banks are the lifeblood of the system.  I like to think of the banks as the oil in the engine.  If you run out oil the system begins to break down and eventually the engine stops running.  You can’t have a healthy functioning economy if the banks aren’t lending.  Unfortunately, because this won’t fix any problems at the household level it won’t induce any borrowing.  So, it’s a clever way to resolve the banking crisis, however, it doesn’t fix the root of the problem which is at the household level.  So, again I ask – is this a “bailout”?   You bet your ass it is.   Unfortunately, it’s not a bailout of the entire system.  It’s just a bailout of the banking system.  And their problems are merely a symptom of much bigger problems at the household level.”

So why are we still muddling through?  Because we fixed the banking crisis and not the household debt crisis.  I believe our leaders failed to properly diagnose the disease and therefore failed to find the cure.  Europe seems to be experiencing a similar crisis.  Many policy makers seem to be mistaking this as a banking crisis so policy is fixed around making sure the banks don’t fail or that the sovereigns don’t default and then cause a banking crisis.  This is shortsighted though.  Europe has a currency crisis which is causing the debt crisis.  So why is Europe muddling through or even in depression in some regions?  Because they’re fixated on avoiding a spreading debt crisis, but continually fail to fix the currency crisis.

Corey:  If fed’s injection of money into the system boosts the stock market, and if the fed does not remove this money, then why should the stock market ever fall?

CR:  I explain QE in some detail here.  Technically, QE doesn’t inject money into the economy.  It swaps bonds for reserves.  So the private sector’s net financial assets are not increased.  The “money printing” is all coming through deficit spending.  And there’s no “debt monetization” going on because it’s impossible for the Fed to ever “fund” the US government (which has a bottomless hole of money that it can create at will).  So you can see why I don’t particularly agree with your phrasing here.

The more important point to understand here is that corporate profits have been largely driven by deficit spending in recent years (more than usual due to the balance sheet recession) so the real risk for the equity market is a large decline in deficit spending leading to a decline in corporate profits and a stock market that corrects as a result.  But this is a separate issue from QE which largely works through psychological channels and does very little to impact the real economy.

JT26:  What do you think is the most overlooked/underrated credit/stock market indicator. (I’ll leave it open-ended, so you can decide what an important indicator means!) Feel free to give us a bonus if you think there is an overrated candidate as well!

CR:  I would say that the most misunderstood or underrated indicator is not exactly an indicator, but rather an understanding of the sector balances and the ways that one sector is directly impacted by the others.  This leads to vast misunderstandings of the broad economy, markets and the monetary system.

Frenchy:  What is your outlook for oil this year and its impact on the fragile recovery in the US? Seasonally we’re approaching the high season and everyone is ditching Iranian oil (major cut backs by 20 to 30% in Asia).

CR:  I wish I knew where the price of oil was going!  I’d be a much wealthier man.  I’m not much of an oil analyst so unfortunately I don’t have a good answer here.

Robert Rice:  Because clearly all these questions are way too easy  I wanted to ask: have you figured out a cure for cancer yet?????? And btw, in 100 years, I need to know who’s going to be President.

CR:  I have not yet discovered the cure for cancer.  But I’ll start making progress as soon as my IQ jumps 50 points and I magically transform into a doctor.  It should happen any moment now….And I don’t have a Presidential prediction for 100 years from now, but I will make a prediction for 2024:  Joe Kennedy III.  I met him a few years ago at a wedding in Boston and talked to him for several hours.  Sharp as a tack, straight as an arrow and a rising start in politics.   The name doesn’t hurt either….

Ray:  Can you explain the impact that QE has had on the USD and also is there any sensible approach to forecasting movements in currencies?

CR:  I don’t see how QE could have substantially impacted the USD since its impact on the real economy is limited.  The US Dollar Index is actually flat since QE1 was initiated so that seems to confirm this thinking.  As for forecasting currencies – they’re largely based on understanding the relative values involved so good currency forecasting essentially comes down to being able to forecast relative economic strength.  Not an easy thing to do and not a game I dabble in often….

Tom Reilly:  Cullen, Do you really believe the Federal Reserve is transparent?? I have already pointed out how one can not tie the published schedule of purchases of MBS to the weekly changes on the balance sheet and as I have also pointed out everytime there is a large increase or decrease in MBS on the balance sheet (and thus an increase or decrease in high powered monetary base juice)the stock market acts accordingly.

CR:  I think our government is incredibly transparent.  Americans often talk about the lack of transparency of government data, but they seem to overlook how transparent the US govt is when compared to other countries.  The amount of regular data releases and transparency through various govt agencies is really staggering.  It’s certainly not perfect, but I think the govt is much more transparent than in other countries where verifiable govt data is often impossible to obtain.

MGK:   Here’s a question I’d love to see Romney answer, but I’d appreciate to read how you respond: If dividend income were taxed as ordinary income, how exactly is this going to change your investment strategy and what impact will that have on the economy and jobs?

CR:  I agree with the Buffett quote below that investors won’t stop investing just because tax rates change:

“BUFFETT:  I have yet– and I’ve worked with capital gains rates of 39.9 percent and 36 percent and 25 percent, I have yet to hear one person say to me, “If I call you in the middle of the night Charlie and I say Charlie I’ve got this hot investment idea.”  Your reaction is not to say “No matter what the tax rate, forget it, I’m going back to sleep because the capital gains rates are too high.”  No, what you’re going to do is you’re going to say, “Tell me the name, quick, Warren, before you change your mind.”  And you know, I have never had one person decline to invest with me.

ROSE:  Yes.

BUFFETT:  And I was running money 40, 50 years ago when rates were much higher and I never had one person to show the slightest reluctance to take an investment idea and run with it”

Dividends are an important source of income for investors and the low tax rate on dividends is a positive incentive for corporations to give profits back to their owners.  One could argue that this is increasingly important given the corporate savings glut.  A tax increase on dividends could potentially exacerbate this and have a negative impact on the economy.  I haven’t done a great deal of work on this area, but my initial reaction is that there’s no need to raise the dividend tax.

Syd:  What do you think would be optimal fiscal policy for the next 1-2 years? Extend the Bush and payroll tax cuts? Extend unemployment benefits? Keep running deficits similar to recent levels? Alter spending levels for existing programs? New spending programs? New tax cuts? Deficit reduction?

CR:  Realistically we’re likely to get tax cuts at best so yes, an extension of the Bush tax cuts and payroll tax cuts are the best we’re likely to do.  A budget deficit of 7-8% of GDP is probably sufficient to sustain growth in 2013 so this might actually do the trick.  In a perfect world I’d revamp the whole system and probably get in there and cut a ton of spending while adding several other policies and initiatives.  I can’t do the details of this justice in this limited space though so it will have to wait for another time….

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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