Looks like the questions got increasingly detailed and difficult this week. Not sure whether to shake my fist at you guys or thank you for the challenge. We’ll see by the end of this I guess. So here goes….
Andrew P - I want to gauge the probability of a true bank run in the PIGS States. A run is only possible if there is somewhere to run to and a real path to get there. How hard is it (in a practical sense) for an ordinary European to get their Euros out of Spain, Greece, Ireland, Portugal, or Italy? I know that in theory any EU citizen can open a bank account in any Eurozone State, and in the past that was true in reality, but The Economist said that German banks are now demanding proof of German residency to open an account. Is it possible for a non-German to open the German equivalent of a Treasury Direct account? If so, what are the operational hurdles to doing so?
CR -Aren’t some citizens already pulling their money out of some banks in Europe? Quite technically, the bank run in Europe is underway to some degree. The money doesn’t have to go anywhere. If enough people pull enough money out of the banks then the banking system starts to freeze up. The more likely scenario is that the strong will devour the weak here and we’ll see something similar to the USA in 2008 where the too big to fail become too BIGGER to fail. It’s a lovely solution until the next big banking crisis happens. :-)
Colin, S.Toe - Recent discussions on ‘federalism’ have reflected the traditional Hamiltonian (strong central government and a central bank; emphasizing and supporting financial/commercial growth) vs Jeffersonian (democracy with a small ‘d’; a nation of independent farmers and tradesmen) divide. I’m not sure either really foresaw the emergence of the ‘entrepreneur’ (particularly in his/her ‘start-up’ incarnation), the multinational corporation, and the dynamic between them.
What reflections would you have on this divide as it relates to economic developments? (This makes up for last week’s lob.)
CR – I discussed what I believe is Hamilton’s prescience and genius in a few posts last year (see here and here). What Hamilton seemed to understand was that a national bank could help eliminate the solvency risk at the federal level which would actually filter through the monetary system and create increasing stability. This is a double edged sword of course. A nation that has its own bank can also abuse this great privilege. But it works fairly well in a nation like the USA where there are checks and balances on the use of that bank.
In Europe, we see the lack of a central bank being tied to political entities as the major cause of the solvency crisis. We don’t have this phenomenon in the USA because the states are all essentially backed by the full faith and credit of the US government. So Hamilton’s bank was a very necessary evil.
whatisgoingon - Question regarding interest swaps/derivatives which reportedly make up over 90% of total derivatives.
1. Has anyone seen if these very large interest rate swaps/derivatives distort the yield spreads of treasuries(similar to how the size of JPM recent bet on HYG distorted the yield spreads)?
2. What risks do the 300 Trillion + interest rate derivatives pose – that is,
a. Is the risk only to the too big to fail banks if the interest rates move against them?
b. Are there risks to interest rates/yields if the bets move against banks and they need to unwind those positions?
I expect the Fed to support the banks if this type of event occurs by intervening to keep rate lows though I’m trying to understand what the likely risks.
CR – This is a tough one to answer. Interest rate swaps exist for good reason – to help banks hedge their risks. Ultimately, banking is all about managing risks. But the unfortunate reality of the financial markets and our banking system is that most banks (and most anyone in general) are not necessarily very good at managing risks. As you noted, the swaps market is enormous, but it’s really impossible to know whether these banks are utilizing these various instruments in a manner that increases their overall risks to the financial system or not. There are a lot of different variables that come into play there. I tend to fall on the side of requiring greater capital controls and tighter regulations on banking activities specifically because I think bankers are poor risk managers. But that’s just me….
SS - Can you elaborate at all on your trading algorithm? Also, is there any way we can gain access to your trading approach? Updates on the site or something?
CR – I do not disclose my proprietary metrics. Sorry.
MG - What is your prediction on the EURO a few years down the road?
CR – I think the Euro will survive and even thrive. I still think Europe must move towards fiscal union of some sort and when they achieve a completion of the union the Euro currency will continue its move towards a world reserve currency.
Sergio - Mr. Roche, I never took Econ 101 and I may be presuming too much. What I don’t understand is:
If most equity investors have allocations in equities at any given time between 50% and 90%….. and many have left the market not to return. Who has been on the buying end from 2008 till now?
By looking at international markets charts that are trending down I might conclude that it was foreign investors taking up the slack. But that still doesn’t account for 08,09.
I assume that 401k buyers are generaly buy and hold. Money is created when it is loaned. Otherwise there is X amount in exsistance at any given time just sloshing back and forth.Yet hundreds of millions of shares trade hands every day and the price keeps going up.
Just can’t rap my head around it. Millions out of the market….. less new loans…..less people buying things……more people unemployed all over the world and the market keeps going up. I’m not sure this is economics…..it sounds more like magic to me. I have a migicians joke that might fit this situation but I won’t tell it because its pretty ronchy.
What are your thoughts?
CR – You have to remember the basics of any market transaction. There is always a buyer for every seller. So it doesn’t make much sense to say that the buyers have “left the market not to return”. When you buy a stock someone else is selling you their cash. And vice versa. All financial assets issued on a primary market are always held in a secondary market until they’re retired. So your question about who has been doing the buying could be answered with “well who has doing all the selling”? Every time you buy a stock someone else is selling it to you….It takes two to tango. And the financial markets are one huge tango.
Vincent - Eric Janszen, from itulip.com, talks about high Treasury rates in the 1970’s, “The response I got [from MMT] is that the US government set the rates high intentionally. Well, no, at one point during the Great Inflation crisis foreign central banks of countries aligned with the US were the only buyers of US Treasury bonds. The US started to issue Treasury bonds in foreign currencies.”
“Markets force the US government to rely on the kindness of foreign central banks to buy UST in 1978. They did this buy (sic) choice? Really?”
Scroll to the end of Part II for his commentary.
Janszens believes in a sudden stop of Treasury funding by investors. Would you care to comment, as he takes a very different view from your explanation of how the bond market works?
I recall the Treasury having to issue “Carter Bonds” in the seventies payable in Marks or Swiss Francs to assist bond sales while inflation was rapidly rising.
Thanks for all you’ve done.
CR – I don’t see what Janszen is referring to. I looked at the Treasury Direct website and the auctions look like pretty much business as usual. For instance, here is the all-time high yield on a 20 year bond at a yield of 15.75% in 1981. The auction went off without a hitch at a bid to cover of 1.8. Remember, the Treasury only needs bids to cover at 1.0 for a successful auction. The other auctions in 1981 (when rates were peaking) were all fairly similar.
Now, is it possible that the USA could lose control of the yield curve? Of course. We have to remember the dynamic at work here first. The government essentially uses the banks as agents to fund Treasury. The Fed is always on watch to make sure payments clear and to help coordinate the whole process here so the Fed and Treasury work very closely on all of this. It is completely possible that the banks could reject their requirement to bid at Treasury auctions. But this would likely only happen in the case of hyperinflation and an environment in which holding Treasury bonds is frighteningly unprofitable (with yields skyrocketing most likely). So the government could lose the ability to harness banks to procure funds and the government would turn to the Fed. But that would likely only occur in a situation in which the currency is collapsing. So yes, it could happen, but I don’t think this is what happened in the 70′s as far as I can tell. Auction demand was just fine.
And remember, I am not using the MMT version of bond auctions where the Fed and Treasury are combined. MMR sees the Treasury as a currency user and the Fed as the currency issuer. We also believe the government needs to procure funds from the private sector in what is essentially a coordinated activity with the banking system. If the banks reject the currency then we’re onto hyperinflation. So the MMT idea that the Fed can just print money in this instance is a moot point. If the government can’t procure funds from the private sector via taxes or bond sales then its monetary system is on the fast track to death. Understanding that the demand for currency is a two sided coin here is absolutely crucial. MMT essentially says “taxes drive money” and that the government can force us to use their currency via enforcement. But money is a social construct and government is a construct of the people. To assume that the government can force us to use the currency or that “taxes drive money” is a deeply flawed idea of the way money works.
John Wilkins - Cullen: I believe you are an expert on inflation and I would like you to comment on the causes of the severe inflation currently in Argentina.
CR – Hard to know what exactly is going on in Argentina since the government there is about as corrupt as they come. They won’t even allow accurate reporting of independent inflation gauges. I do know the government has been highly expansionary in recent years and while I am not an expert on Argentina the current bout of inflation sounds like a case of printing in excess of productive capacity and massive government incompetence.
Old Dog - Cullen: Do you think that Fiscal Policy is in many ways too important to be left in the hands of the politicians? (I know that is how the constitution set it up but the pols clearly do not understand how it works.)
CR – I would prefer that fiscal policy became increasingly automatic. My MMR colleague, Mike Sankowski, has proposed his TC Rule, which I think is very innovative. It essentially ties the govt budget deficit to inflation and unemployment. The policy could easily reset automatically by lowering or reducing tax rates on occasion. I personally prefer the tax route as that takes the bureaucratic decision making out of the process…..
Perpetual neophyte - http://www.creditwritedowns.com/2011/09/expectations-theory-of-interest-rates.html
I’d like to hear your thoughts on Ed’s perspective of the expectations theory of interest rates. Specifically from an actionable investment premise: would you interpret it to mean that – if short term rates remain pegged towards zero by the Fed for longer than expected – there is still room for intermediate and longer bonds to move toward zero?
CR – I always like to think of the long bond like a dog on a leash. We know the Fed sets the short rate, but the market controls the long rate to some extent. And what the dog does (the bond traders) is try to front run the Fed and their actions at the short end. So if the Fed were to come out later this month and hint at rate increases you’d see a massive rise in long yields as bond traders began to front run the Fed and a cycle of rate increases. But what’s happened in recent years is the dog has run out in front every time the economy starts to look a little stronger and then the Fed yanks them back by reiterating that they will keep rates at zero. Right now the Fed has been pretty clear that we have a few more years of low rates so the dog is being a good boy and sitting nice and close to his owner. He’s been yanked at the neck so many times since 2008 that the lesson has apparently been learned….
Kostas Kalevras - I ‘d like to hear your suggestions for a poor man’s bloomberg terminal. My own recommendations are:
1) bloomberg account and using ‘market monitor’.
2) http://www.euribor-ebf.eu/ for various euro interest rates.
3) http://www.investinginbondseurope.org/Pages/BondMarketsAndPrices.aspx?folder_id=326 for bond prices.
4) http://www.boerse-frankfurt.de/en/start for per ISIN price quotes.
5) http://www.dtcc.com/products/fi/gcfindex/ GCF repo rates.
CR – You don’t need a Bloomberg terminal to do well in this business. In fact, the data overload likely hurts a lot of people who aren’t in a specific niche where the data is a huge help. For the average investor though, there’s nothing you need to access on the Bloomberg that you can’t access through most financial websites. That said, there’s no replacing the Bloomberg terminal if you have it. Reuters Eikon is probably its closest competitor, but I haven’t used it.
quaternion - I wave my wand and Angela Merkel relents and all problematic, PIIGS sovereign debt is swapped for eurobonds. Do equity markets worldwide snap back to their post-2007 highs (or higher) or do they continue to struggle because of underlying economic problems in the US and abroad?
CR – If we get Eurobonds we’ll see a massive convergence in all European yields. This would be a huge risk-on event. It won’t solve all of Europe’s problems, but it would eliminate the solvency risk which would take a huge risk off the table. Stability in Europe will help stabilize the global economy. So yes, huge risk-on event and I would go so far as to say the beginning of the end of the Euro crisis.
jjames - please explain how the fed creates money out of thin air.
CR – It’s best to think of the US Treasury as a currency user and the Fed as the currency issuer. The US government as a whole is able to harness the Fed and the banks as agents of the government to create what is essentially a currency issuer at the government level. That is, the Treasury can always procure funds by using the banks and the Fed in a coordinated effort. So the government procures funds by taxing the private sector which results in credits in the Treasury’s account at the Fed. When the government cannot procure enough funding through taxation they will sell bonds. They do so by harnessing the banks as agents, who are required to bid at Treasury auctions. The Fed helps coordinate these operations to maintain a healthy payments system and ensure that reserves are abundant to settle payments. When the Treasury sells bonds net financial assets are created as reserves are swapped for bonds and the resulting spending from the procurement of bonds adds to the financial assets of the private sector.
Kman - I haven’t had a chance to read too much detail of the new “Spanish TARP” but my take away is that this is a 100Billion Euro Loan. This everyone has said. What I can’t find anywhere is what the interest rate on this loan is to be. If it is less then 6% then shouldn’t the Irish be really and legitimately pissed off? They were forced to accept this interest rate AND austerity as part of their bank recapitalization scheme while Spain gets a mulligan.
CR – The short answer is yes. And they are pissed off. See here.
Anonymous - I know this is a macro blog, but still what have been your personal thoughts / comments about the Facebook IPO? Do you see a trend?
CR – I wasn’t as disturbed by the Facebook IPO as everyone else out there. Facebook IPO’d so they could raise money. And the underwriters are there to service the issuer and ensure that the issuer raises as much capital as possible within a reasonable range of their expectations. So I don’t think it’s all that crazy that they took Facebook public at $100B or whatever it was. What was not okay was the allegation that some of the underwriters knew the stock was substantially overvalued and had actually downgraded their outlook while disclosing this to some clients.
Kamala - Cullen, Thanks for your site. Great info always. What do you think will happen with treasuries and equities after Operation Twist ends this month? Will the Fed announce another operation? Will they wait till after the Nov. elections? Will the market move sideways with a lot of volatility?
CR – I’ve been accumulating into this downturn. I am not optimistic about the economic impact of QE3 or operation twist, but that doesn’t mean it can’t serve as a catalyst to keep a bid under the market. It could turn out to be a typical buy the rumor and sell the news type of event….
Bill - Cullen, just curious if you have any correspondence with other market and econ writers outside the whole MMT community.
CR – I actually don’t talk to many MMTers. Probably because I am not an MMTer. MMR and MMT have really split ways this year (see here if you haven’t read the many differences). I mostly correspond with my MMR colleagues. Other than that my contacts are mostly in the banking and investment world. Remember, I am an investment manager who plays an economist on TV. :-)
freemarketeer - What are the important lessons you have learned since you began your career? What did you wish you knew when you were starting out?
CR – Gosh, that’s a broad one. One of the more important lessons I’ve learned is that you can’t do everything on your own. There really is no such thing as a “self made” person in this world. That is, we all rely on support systems, customers, and other people to achieve the things we seek out to accomplish. I spent the first few years of my career trying to do everything on my own without ever consulting other people. Understanding that money is a social construct is important here. When you realize that money is a tool that helps us all in the exchange of goods and services then you begin to acquire a better appreciation for the goods and services that back the entire economy. We’re not just collecting pieces of paper. We’re providing other people with goods and services they desire and we’re just keeping tabs by debiting and crediting bank accounts. But the key thing to understand in all of this is that in order to acquire credits in your account you have to provide the world with something truly valuable. And no one can do that without help.
whatisgoingon - One more question. Given the theory of fiat money as described by MMT and MMR, how do you reconcile that central banks are net buyers of gold? Why not sea shells? (From what I gather the central bank buyers are the developing/emerging economies rather than the developed ones).
CR – Central banks implement lots of weird policies. Some of them are smart and some of them are not so smart. Buying gold is more a rainy day policy than anything else. I wouldn’t read into it too much.
jt26 - I’m thinking Pimco has got it right that QE3 will come soon and they will resume MBS purchases. First, it avoids your much-criticised like-for-like asset swap of buying gov bonds. Second, it will directly impact the largest part of consumer balance sheets (liabilities). Third, housing seems to be showing signs of life, and the Fed may think this could be the right leveraging point to spark a new mini-bubble in RE. What do you think?
CR – I don’t think buying MBS will make a huge impact over buying Treasury’s. It worked better in QE1 when MBS was getting smashed and the Fed came in to calm markets and help bolster prices, but the current environment is nothing like that. MBS doesn’t need the Fed’s support. So I don’t know what this accomplishes. It’s an asset swap with no real substantive effect on the macro economy…..The whole QE2 and QE3 policy response is a waste of breath in all honesty. I’ve never seen a set of programs that did less, but garnered more attention…..
Exertia - Your thoughts on the Economist cover and this rejoinder by a German website
CR – Last I checked the Germany’s PMI was deeply in the contraction range while the USA’s was still expanding. So it seems that image is a bit backwards. It’s the Americans who are above water and the Germans who are sinking fast. But I guess it’s nice that the Germans still have their sense of humor about the pain their indecisiveness is helping to cause. :-)
Hangemhi - A recent polifact story explained that other than the stimulus bill, Obama hasn’t been spending. Annual gov spending increase is 1.4% or lowest of the past 10 presidents. However, deficits and the debt are very high. The question…. if deficits are due to lower tax revenues rather than new spending, does it have less impact on growth/GDP vs new spending? On one hand it seems like a dollar is a dollar is a dollar, but on the other one just doesn’t take old spending out, while the other injects new spending in. So isn’t the latter more stimulative?
CR – A deficits a deficit. The govt can either take fewer dollars from us or they can spend more into existence. Either way it results in a larger budget deficit. So yes, we might not be spending as much, but we’re also not taxing as much. So the net result is a big budget deficit.