Q&A…The Answers, Part Deux

Sorry to break the Q&A up like this (part 1 is here), but the site redesign and a bunch of other things really crunched my time over the last few days.  Here’s the second instalment of the Q&A:

CW:  I recently read “Currency Wars” by James Rickards which was a very provocative book and a good history lesson on international currency systems, however the conclusions did not flow from the premises in my opinion.

However there was a paragraph that stood out for me and I was curious about your opinion on it:

page 199, Behavioral economics possesses powerful tools and can offer superb insights..Exploration of the paradox of Keynesianism is one possibly fruitful area of BE research…Keynesianism was proposed in part to overcome the paradox of thrift…government spending was thought to replace this shortage of private spending..Today government spending has grown so large and sovereign debt burdens so great that citizens rightly expect that some combination of inflation, higher taxation, and default will be required to reconcile the debt burden with means available to pay for it. Government spending, far from stimulating more spending, actually makes the debt burden worse and may increase this private propensity to save…The result may be the discovery that short-term austerity brightens long run economic prospects by increasing confidence and the propensity to spend.”

I think this is quite a profound insight. I found myself thinking about Canada in the 90′s which was a basket case until some austerity was put in place and confidence was regained in the economy. I am sure there are other examples.

Perhaps at debt levels in excess of 100%, government spending actually retards growth prospects contrary to the conventional wisdom.

CR:   Attaching a number to the debt:GDP figure just strikes me as such an arbitrary way to view these things.  It kind of reminds me of the idea that money printing = inflation.  Well, yes, if the money is used!   The same goes for government spending and debt levels.  How are they being used and what is the real impact of the spending?  Economies are not static systems.  You can’t just say “this economy has reached X% of debt therefore it is destined to fail”.  The more important understanding is that an autonomous currency issuer, like the USA, is not constrained by the amount of debt it issues, but rather by the inflationary effect of the spending.  So to me, focusing on debt:GDP ratios is the wrong metric.  Rather, we should be focusing on fiscal policy that most benefits the private sector and encourages optimal resource utilization.

KMAN:  To focus my previous question (about the 70′s stagflation). What I am looking for is the MMR explanation of the phenomenon of “stagflation” during that period. on the surface it seems to invalidate some MMR tenets. If you have high inflation this implies too much money creation for the amount of goods produced. High unemployment implies insufficient money in the system. How do both exist at the same time?

CR:  I don’t think the 70′s invalidate MR at all.  After all, at its core, MR is really just a set of understandings about the way the system works.  To me, the 70′s were a confluence of many moving parts.  The key drivers of the stagflation were the war spending, strong unions (leading to high wages), and oil prices.  Combine the three and you got an unusual mix of  demand push-inflation and cost-push inflation.

Bald Trader:  Cullen,2 questions:

1)Per MMT, a government does not need tax revenue to ‘fund’ its spending on social programs. So why does a socialist country such as Sweden or Denmark have such high taxes?

2)It seems like foreign denominated debt gets countries in trouble. They can no longer ‘print money’ to stimulate their economy, as this will devalue their currency and make foreign debt repayments more difficult. Why do countries borrow in foreign denominated debt?

CR:   I don’t use the MMT framework here any more.  Monetary Realism, which was created to clarify what many of us believe were errors in the MMT framework, shows that government’s really go have to procure funds from the private sector in order to spend.  It’s important to understand that an autonomous currency issuer can’t “run out of money” because it can always harness its banks or central bank as a funding source, but that doesn’t mean the government isn’t always a currency user in some aspect.  That is, government’s must achieve validation of the existence of their currency in order to use it.  This is done via taxes and bond sales.  A government that cannot tax has a dying currency on their hands.  Every single hyperinflation in history has proven this.  So it’s pointless to say a government doesn’t need to procure funds to spend.  It most certainly does.  As a user of OUR social construct, the government has elements of a currency user that must be understood or else you misunderstand the very essence of money as a social construct.

That said, countries that have highly socialized spending policies must tax more to procure funds for these programs.

On point two, not all countries can be sovereign in their currency due to real constraints or other factors.  So some countries just don’t have a choice in adopting the policies of other nations.  China is a classic example here.  China is not really autonomous in the RMB because they peg the currency to the USD.  Why do they do this?  Because their economy is not developed to the point where they feel comfortable letting the RMB float fully.  They choose not to be autonomous, but they are making the conscious decision to do this because they feel it benefits their citizens most to drive exports through keeping the RMB low relative to the USD.  So China has to accumulate USD’s to protect the RMB peg in essence making them a user of a foreign currency to some degree.

I would recommend reading this piece on currency autonomy by Brett Fiebiger for more.  http://monetaryrealism.com/the-international-dimensions-of-currency-autonomy/

Ben:  Cullen, Which market outcome in the next 6 months will cause you the most pain?

CR:  A Euro collapse would be really devastating for everyone.  Not only would it render many of my predictions wrong, but it would also inflict massive pain and suffering on the global economy.  This would inevitably impact me in many ways, but more importantly, it would hurt just about everyone in the global economy.

SB: This may seem like a silly question, but I’m curious why your recent post on money supply used M3, which doesn’t include treasuries. As I understand it, MMR holds that people treat treasuries an awful lot like money, so swapping them with dollars doesn’t really change anything, which is why QE isn’t really money printing. So should we really be using a monetary aggregate that includes treasuries? What am I missing here? 

CR:  I really just used M3 because it’s the money supply indicator that most people are most familiar with.  But if we want to gauge inflation there’s much more to that equation than just the money supply so any metric implying rates of inflation solely based on the money supply is lacking.

Calvin:  Why are women SO CRAZY?

CR:  They spend much of their lives trying to find a reasonably decent man, then he more often than not turns out to be a jerk, and by then they’re usually raising a smaller version of this jerk who will rinse, wash and repeat the cycle.  That would probably drive me crazy also.  Luckily, I am not a woman!   That should get me in trouble with just about everyone!  Please sense the sarcasm here!  

David:  1. Do you think that soccer would be more popular in the USA if they did away with offsides and penalized players for faking injuries to the point of embarassing themselves along with everybody in the stadium for being so lame.

2. Now that Obamacare is declared a tax;does this, along with current tax breaks expiring, adversely affect 2013 economic growth?

It is confusing to me how they insist the money comes from taxes to pay for this when it doesn’t have to. I am so confused….

CR:  I really enjoy soccer, but I do wish it was a bit more exciting.  The lack of scoring can make for a tough 90 minutes at times.  I wish they’d implement a blue line like hockey.  Or something similar.  You don’t want to eliminate break-aways (which are usually the most exciting style of play in any sport), but you also don’t want unrelenting cherry picking.   Hockey seems to have this figured out.  Soccer needs a better balance.  They’ve eliminated the slam dunk breakaway and anyone who has ever watched a Top 10 on Sports Center knows that without the breakaway slam dunk highlight there’s almost no point watching.

On the healthcare plan, I am not exactly positive what the deficit effect will be here, but I believe it will be a spending increase overall….Maybe someone else knows?

Basic:  For someone who does not have any economics background,

What are bank reserves?
If someone opens a new bank, how that bank gets their initial reserves?
Is there any connection between bank capital and reserves they have?

Thank you in advance for clarifying these very very basic (stupid?) questions.

CR: Reserves are deposits held at the Fed as well as cash reserves.  These are held to maintain settlement of payments and cash withdrawals.  Banks must have reserves in accordance with the specific regulatory requirements.  In the USA, there is a 10% reserve requirement.   Reserves are an asset.  Capital is assets minus liabilities.  So a bank can have plentiful reserves and still be insolvent.   Remember, banks don’t lend reserves!  The money multiplier is a myth.

JK:  Cullen, Are there any “Conspiracy Theories” that you belieive to be legitimate? (9/11 being an inside job, aliens have been visiting and governments are hiding it, etc.)

CR:  I’m not big on conspiracy theories.  But I’m not oblivious to the fact that our government probably hides some things from us.  I’ll just leave it at that.

JT26:   Are there more concrete metrics to gauge whether the federal debt matters or not? There have been many points of view:

(a) TPC view (hope I’m paraphrasing correctly): as long as the debt is productive it doesn’t matter. Question: how do we quantify this? (For example, most of the recent investments have been in real estate which is hardly productivity enhancing; what America is really selling is citizenship, not houses, but I guess you need the houses to begin with!)
(b) Krugman et al: it’s debt we owe ourselves, it never matters. There is no intergenerational debt; it’s just debt our children owe themselves.
(c) Rowe: intergenerational debt matters
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/12/debt-is-too-a-burden-on-our-children-unless-you-believe-in-ricardian-equivalence.html
(d) source??? federal debt doesn’t matter at all as long as private debt is productive. Federal debt is just grease for the wheels; the amount doesn’t matter as long as you have enough.

I’ve probably missed some as well. Thanks!

CR: The Federal debt certainly matters.  It just doesn’t matter in the same way it matters for a household.  Ie, we’re not going to “run out of money”.  I like to measure living standards.  This is a very difficult thing to measure since living standards are different to different people, but one way is to measure the real wage and salary disbursements per capita.  Other measures are more subjective.

Pierce Inverarity: Why do banks purchase deposits from other banks in a deleveraging environment?

CR:  Banking is a business of risk and earning a spread on one’s assets versus liabilities.  Banks want the cheapest liabilities they can find.  So banks are always trying to obtain the cheapest liabilities they can.  None cheaper than deposits.

Exertia:  Cullen, thanks for the recommendation about Jack Schwager’s books:

http://pragcap.com/hedge-fund-market-wizards

I am going through all 4 of the wizards series (cherry picking the managers I know of, and also going thru the author’s concluding remarks) and they are fantastic.

You had specifically called out Ray Dalio’s chapter (HFMW, Ch.2) and his analysis is brilliant. However he does strike a pessimistic note for the US concluding that we are in a stage of decline that may stretch 20 years into 2030. How do you reconcile this with your long-term, optimistic view of the US?

CR:  I might be naive, but I just don’t buy into the notion that the USA is going to suffer a Japanese style 20 year deflation.  I think we’re “Japan on fast forward” because we’ve implemented so many of the fixes so much more quickly than Japan did.  So the de-leveraging cycle is not likely to last as long as Japan’s did.  And in fact, we’re already seeing signs that the USA’s de-leveraging is ending….

Python:  Two questions regarding technical analysis:

1) Is technical analysis applicable when the market is
heavily driven by non-business news, or business news not
entirely relevant to U.S. business? Note: the market has
been heavily news-driven the past two months, but I would
argue that the direct relevance of most of that news
(i.e., regarding PIIGS sovereign debt and bank solvency)
to U.S. equities is questionable; nonetheless, several key
technical analysis support levels have been breached during
that time.

2) Technical analysis is really a set of statistical correlations,
but current market conditions, characterized by recovery from
a balance-sheet recession, are markedly different
from what would have prevailed when the preponderance of those
correlations were compiled. Would that not somehow mitigate the
effectiveness of technical analysis? Note: I’ve read many investors
complain on this and other investment websites that the market-
forecasting tools (technical and otherwise) they usually employ have
worked poorly since the balance-sheet recession started in 2007.

CR:  Technical analysis is really just a rear view data point form of fundamental analysis.  Anyone who collects historical data and technical analysis of any kind is just using past reference points to predict the future.  The past and present rhyme, but they don’t often repeat.  So technical analysis is useful in offering perspective, but not infallible.  Charting is not just TA.  It is a separate approach.  It is just the visual representation of these past data points.  I find both approaches useful, but only as complements to good fundamental analysis.

Anon:  There appears to be an optimism that the American government “debt” can be corrected. I do not hold that view. The American government “debt” is here to stay as is the Eurozone “debt” and the UK government “debt” and the Japanese government “debt”. I keep asking myself “how will all this government “debt” get resolved”. Can it stay around for ever….?

Can the HH debt stay around forever?

CR:  The US government is never going to “pay back” the debt.  That would entail the elimination of all US govt saving bonds.  Does your grandmother ever say “I wish Uncle Sam would pay off the national debt so I could get rid of these damn saving bonds!”???  Of course not.  The government’s debt is the non-government’s saving to a large degree.   The govt doesn’t need to “pay off the national debt”.  It needs to be harnessed by its users in a way that results in more efficient spending lading to the optimal allocation of resources.  Inflation is the true constraint for an autonomous currency issuer.  NOT solvency.

Andrew:  What do you think about this expedient option for Europe – a devaluation of the Euro?

http://www.businessinsider.com/new-euro-bailout-devalue-2012-7

I assume the ECB could do this by printing and would not need international coordination.

CR:  Devaluation does not solve the crux of the issue here.  Europe has a currency crisis.  They have created an incomplete union in which its nations are all currency users susceptible to solvency crisis.  This must be rectified by creating an autonomous currency system.  Devaluing might help bolster growth in the near-term, but it’s not a long-term fix.

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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