Derivatives and the Credit Bubble

In principle, there is absolutely nothing wrong with derivatives. They serve a valuable function, by transferring risk from those who don't want to be exposed to it to those who are willing to take risk on in their stead for a fee. However, since the adoption of the pure fiat money system, credit growth has literally gone “parabolic” all over the world. This growth in outstanding credit has been spurred on by interest rates that have been declining for more than three decades.

Larger and larger borrowings have become feasible as the cost of credit has fallen, and this has in turn spawned an unprecedented boom in financial engineering.

When critics mentioned in the past that this had created systemic dangers, their  objections were always waved away with two main arguments: firstly, the amount of net derivatives exposure is only a fraction of the outstanding gross amounts, as so many contracts are netted out (i.e., things are not as bad as they look). Secondly, the system had proven resilient whenever financial system stresses occurred. Perhaps not as resilient as it seemed, considering that these crises as a rule required heavy central bank interventions and/or bailouts in various shapes and forms. Would the system have been as resilient if those had not occurred? We have some doubts with regard to that.


total_derivativesSince the crisis, derivatives growth has stalled, but the notional amount has returned to its record highs as of the end of 2013 – click to enlarge.


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WGC Continues Not to Understand Gold Market

The WSJ recently reported on the latest gold supply-demand report issued by the World Gold Council. It isn't really a surprise to us, but it is nevertheless astonishing that an organization that is supposedly focused on gold can get the market's most fundamental aspects so utterly wrong. The WSJ article is entitled Global Gold Demand Down 16%”. That sounds like a lot, right? Here are excerpts from the article:


“Global demand for gold slumped in the second quarter as Chinese and Indian buying returned to more stable levels following a record-breaking quarter a year earlier, the World Gold Council said Thursday.

"This is a gold market that is returning to balance," Marcus Grubb, managing director of investment strategy at the World Gold Council said in an interview. "These figures reflect the exceptional quarter that was second quarter last year where we had large outflows in exchange-traded funds on the one hand and a very significant increase in physical buying on the other."


China and India, which together account around half of global gold demand, purchased 193 tons and 204 tons of gold, respectively, in the second quarter—a sharp drop from a year earlier.


Total demand for gold was 964 metric tons in April to June, down 16% compared with 1,148 tons during the same period in 2013, the industry body said in a quarterly report. Demand for gold used in jewelry dropped by almost a third to 510 tons in the second quarter, from a year before.

The World Gold Council expects India to buy between 850 and 900 tons of gold this year, down from 975 tons last year. China is expected to buy between 900 and 1,000 tons, down from the record 1,275 tons of demand last year.

Central banks, meanwhile, bought up a net 118 tons of gold in the second quarter, a 28% jump from the year before. The main buyers were the central banks of Russia and Kazakhstan, reflecting the appetite of emerging-market countries for a hedge against dollar exposure in their reserves.

After the sharp selling in the second quarter of 2013, investments in the latest quarter rose by 4% in the three months through June, to 235 tons, reflecting more stable demand for exchange-traded funds, the WGC said.

"Investors are now comfortable owning gold again in the form of ETFs and we've seen a very significant stabilization," said Mr. Grubb.

Overall supply of gold to the market—including mine supply, recycling and producer hedging—rose 10% in the second quarter to 1,078 tons, while mine production rose 4% to 765 tons, according to the WGC.


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A Reader's Take on Piketty – Belmont Boy Unconvinced

One of our regular readers who is occasionally in e-mail contact with us, recently informed us that a friend of his, who is currently off to fight forest fires somewhere in California (this explains the reference to smoke you will encounter further below), breathlessly regaled him with praise for the neo-Marxist theses of Mr. Piketty.  Our reader, who goes by the handle of “Belmont Boy” dutifully started to read Piketty's tome, so as to be able to provide informed comment. Below you find his initial impression, which essentially refers only to the book's introductory section. We have highlighted a few passages of his commentary we believe are especially noteworthy:


“God, this guy is wordy. I'm still plodding through his intro. His premise is that unequal wealth distribution should be the focus of economic analysis. Why? Because people tend to be envious? Why shouldn't "growth" be the center? He talks about growth as if it just happens, with no acknowledgment that the industrial revolution could not have taken place without an accumulation and concentration of capital.

Of course it took time for wages to catch up: capital kept getting reinvested, and the result was the production of goods on a massive enough scale that "the masses" came to benefit. Good thing there was no onerous taxation of capital back then. It would have only served to constrain growth. Good thing no governmental central planners directed the allocation of capital. Cronies, to be sure, would have prospered…at the cost of lower growth yet.

Myself: I think it's rather nice that in the "developed" world, at least, virtually everyone has electricity, clean water, indoor plumbing, phones, cars, and gadgets galore. It wasn't long ago that even kings had none of that. So what if some contemporary megalomaniacal a**holes have eleven houses, eight yachts, and three airplanes?

If he's so concerned about income inequality, he should examine why government functionaries (and academic economists) make so much more than people in a vast array of jobs who, unlike them, produce useful goods and/or provide manifestly worthwhile services.

If he did bother to examine that, he would discover the cause is extraction of wealth from the productive sector of the economy (via taxation and inflation) and its reallocation by Our Betters to activities, and to other Betters, with utter disregard for the fact that said reallocation only squanders capital. While it buys votes, of course, for those of Our Betters known as politicians.

It's a curious thing: the most "unequal" distribution of wealth has always seemed to take place where there is the greatest centralized concentration of power. And it's curious that, in such places, aggregate wealth, even where it once amounted to a lot, ends up amounting to not-so-much.

How can you expect me to take seriously a guy who misunderstands so fundamentally, he can write: "The price system plays a key role in coordinating the activities of millions of individuals…"? There is no "price system." Prices are nothing but manifestations of the choices made by millions of individuals, who may often prefer not to "coordinate" their activities at all. That is what prices are, and it is all they are. Except when agents of centralized power, legitimized and facilitated by hyper-miseducated fools who concoct absurd concepts (like "price systems") which invite coercion, invoke those concepts to justify their manipulation of prices and imposition of costs on people who would like to think they are free.

I shall look forward to arguing with you soon in person. Preferably about something other than the cockamamie ideas of Monsieur P. Meanwhile, may all that smoke around you blow elsewhere, may your air be clear and sweet.”


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Is the Shiller P/E Broken?

By Chris Hunter, editorial director Bonner & Partners 

One of the water-cooler conversations at Bonner & Partners is whether the Shiller P/E – the valuation ratio popularized by Yale economist Robert Shiller – is worth a damn. If you’re not already familiar with the Shiller P/E, here’s a quick introduction…

The standard price-to-earnings ratio looks at a company’s share price compared to its per-share earnings. And it either looks at per-share earnings from the last four quarters (known as the trailing P/E)… or from the expected per-share earnings for the next four quarters (known as the forward or projected P/E).

The Shiller P/E works a little differently. Instead of dividing stock prices by per-share earnings over the preceding 12 months… or using per-share earnings estimates for the next 12 months… it divides stock prices by the inflation-adjusted earnings over the preceding 10 years.

According to Shiller, his measure (also known as the CAPE, which stands for “Cyclically Adjusted Price-Earnings”):


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The Advantages of a Celtic Temperament

We are doing a quick tour of Britain and Ireland, catching up on business. No time to write much this morning… We need to rush to a plane.

The weather, generally, is terrible. Cold. Windy. Rainy. It is mid-August, but it could pass for mid-winter in most places. Here in Ireland the sun barely shines. Not that this dampens our spirits or decreases our joy. Those were long gone before we boarded our plane in Limoges, France.

Yes, dear reader, we have a Celtic temperament. We have periods of happiness and contentment, but we count on our deep sense of cynicism and gloom to get us through them.


MissionAccomplished(Photo credit; Juan E. Diaz)

This makes us well suited to our job. At Bonner & Partners – the new publishing venture we’ve set up with our eldest son, Will – we are forward lookouts… scouts on the financial frontier. We keep alert at all times… and expect an attack at any moment.

Often, we mistake a skirmish for a major battle. And often, we think we see a major assault that turns out to be only a raid. But you never know …


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Austria Threatened by Apple-Berg

It turns out that Austria's apple growers are also victims of the counter-sanctions recently imposed by Vlad the Terrible in the form of a new diet plan for Russia. How could you, Vladimir Vladimirovich? Haven't the Austrian's dutifully signed off on South Stream, in a rare display of political sanity?

As the Austrian press reports, a cunning plan to blunt Putler's perfidious revenge on the EU is in the works:


“Russia's import ban for perishable foodstuffs also hits Austria, minister of agriculture Rupprechter calls for more fruit and vegetable consumption.


In Austria, agriculture minister Andrä Rupprechter wants to primarily boost domestic consumption, as according to a report in the “ORF Morning Journal” [local TV station, ed.],  local fruit growers are already feeling the effects of the lack of exports to Russia: Thus prices for apples have declined already prior to the main harvest. Rupprechter calculated the losses for Austria's agricultural and food sector overall to amount to 4.5 m. euro as last week  already, the report stated further.

Austria's population could however help, by focusing its consumption on domestic fruit and vegetables. “If everybody eats one additional apple per week, we could handle losing this market”.


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The Current Path of ECB Policy

While the ECB keeps talking about what it might possibly do, its actual policy choice is a rather odd mixture, as Sharmila Whelan of Asianomics recently pointed out. On the one hand, it is evident that a policy of internal deflation has been embarked upon in the euro area.

However, on the other hand, this is combined with a policy of “pain avoidance”, which we can see by the frequent reactive ECB decisions to temporarily inject liquidity again with instruments such as its LTROs (and their new bastard child TLTRO) and keeping administered rates at ridiculously low levels, as well as by the continued increase in government debt. As we have previously noted in these pages, to the extent that credit expansion has taken place in the euro area in recent years, it has been focused almost exclusively on the funding of more government spending.

The private sector by contrast continues to slowly deleverage (see our previous article “Euro Area Credit and Money Supply”, which contains a recent update of the most important data points in this context).

Naturally, this combination of policies makes little sense, as it simply serves to prolong the pain of the adjustment. If the ECB and other policymakers in Europe were to let market forces make short shrift of the remaining bubble activities in the euro area, there would be a sharp, but short recession. This would indeed be quite painful, but it would also lay the foundation for a sustainable upswing. However, one would have to be politically prepared to endure the considerable short term pain associated with this approach, and a great many impediments to price and wage adjustments would have to be removed beforehand.

The current period of relative calm is likely to soon give way to a more “interesting” time period again, in the Chinese curse sense. This is so, because money supply growth in the euro area is recently decelerating significantly.


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No “Inflation Worries”

Ahead of the Jackson Hole pow-wow, where a bunch of central bankers and establishment-approved intellectuals advising them will soon meet, it may be worth taking a look at what motivates the policies of the new Fed chair. On August 12, Bloomberg reported – employing its inimitable style of headlines construction -  that “Yellen resolved to avoid raising rates too soon, fearing downturn”. Bloomberg elaborates:


“Approaching a historic turn in U.S. monetary policy, Janet Yellen has staked her tenure as chair of the Federal Reserve on a simple principle: she'd rather fight inflation than another economic downturn.

Interviews with current and former Fed officials indicate that Yellen and core decision-makers at the U.S. central bank are determined not to raise interest rates too early and risk hurting the fragile U.S. economy.

It's a commitment that will be vigorously tested in coming months as pressure builds inside the Fed, among Republicans on Capitol Hill, and perhaps even in financial markets, for the Fed to acknowledge a strengthening U.S. economy with its first interest-rate increase in more than eight years. A global central bankers' conference in Jackson Hole, Wyoming next week will give Yellen a major stage on which to press her case.”


(emphasis added)

To this it must be kept in mind that the definition of “inflation” has been twisted over time to represent one of its possible effects rather than the thing itself. Prices obviously cannot be “inflated” – they can either rise or fall. What can be inflated is the money supply, and until large parts of the science of economics began to retrogress from the late 1930s onward, this was precisely what economists held to be the meaning of the term. In short, “inflation” once designated the increase in the money supply. However, Bloomberg, Ms. Yellen and her fellow Fed members use the term “inflation” to refer to the mythical “general price level”, specifically the rate of change of consumer prices.

Why is there no such thing as the “general price level”? Even our largely disembodied digital money is essentially a good with its own supply-demand characteristics. If one compares the array of price ratios it forms with other goods against which it is exchanged, there are two problems:

Firstly, since both money and the goods one exchanges it for are subject to the laws of supply and demand, there exists no fixed yardstick – if one e.g. looks at the money price of oil, it is simply not possible to know to what extent its height is influenced by the supply of and demand for money, or the supply of and demand for oil.

The second problem is that by adding up an entire array of money prices of disparate goods, one arrives at a number that is devoid of logic.

To see why consider the following sentence: “1/25,000 of a car, plus one movie ticket, plus two pounds of potatoes, plus one fifth of a massage, plus ½ of a haircut, plus 1/500 of a personal computer, equals….” -  when it is put in this way, it should be immediately obvious what the problem is. An “average” of cars, potatoes, haircuts, etc. is inherently meaningless.


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A Plague of Motorized Wheelchairs

Dow up another 175 points. Wee! Corrupt money corrupts everything it touches. Do you remember, last year about this time, we saw two guys in electric wheelchairs racing each other down Eutaw Street in Baltimore?



(Photo via Wikimedia Commons / Author: 2bgr8)


The local liquor store must have been getting ready to close. All over the city you see these motorized wheelchairs. You may wonder how people got around before they were invented. They probably walked. Or powered their wheelchairs with their own arms.

You may also wonder whether eliminating the need to use arms as well as legs is such a good thing. Finally, you may wonder how so many poor people are able to afford such fancy wheels.


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Move Over Atkins …

The sanctions tit-for-tat between the EU and Russia that is making so many headlines is economically less important than it appears on the surface, at least in terms of its direct effects. All actors in the game have taken great care not to hurt each other too much, mainly out of fear of hurting their own economies. The financial sanctions against Russian banks probably smart the most, but even those can be easily backstopped by Russia's central bank, which is sitting on a sufficiently large cushion of foreign reserves to be able to replace a fair chunk of foreign financing (about 30% of the funding of Russian banks comes from foreign sources, so it is not a trivial event even so).

We were slightly astonished though by Vladimir Putin's idea to alter the diet of Russia's citizens by banning fruit, vegetable and dairy imports from the EU. A friend of ours (who was born in Russia) recently came to visit us, right after visiting St. Petersburg.  As he told us, most people living in Russia's countryside probably can't afford to buy much imported food, but it is very different in the big cities (especially Moscow and St. Petersburg), where the higher earning strata of the population tend to be concentrated.

Not only is the ban hurting Russian consumers, it is also a big problem for a great many restaurants and hotels in these big cities and seriously impedes their business. We realize of course that these food-related sanctions were chosen a) because it is probably held that it will be easy to defend them against WTO complaints (one can always fall back on health-related pretexts) and b) because of their effect on specific countries in the EU; they obviously don't hurt all EU countries to the same extent. It is probably not a coincidence that among the countries most affected one can find many that traditionally take a dim view of Russia and have recently campaigned for tougher EU sanctions against Moscow.

Poland's apple industry and Finnish dairies come to mind in this context. Polish apples have recently been rechristened “freedom apples” (remember “freedom fries”?) in the hope that this will attract new customers in the US for reasons of solidarity with Ukraine and agreement with the plan to wrench it away from Russia's sphere of influence. The problem with this idea is that US consumers are a fickle bunch and most of them probably can't even find Ukraine on a map. The average citizen likely has far less interest in what happens in the Ukraine than the political elites (for instance, Hunter Biden likely wants to drill in Lugansk, but there's no mileage in this for anyone else). Also, “freedom fries” were associated with Bush jr.'s Iraq intervention, which can be safely called an ongoing failure of truly monumental proportions. Not that there's anything wrong with Polish apples, but “freedom apples” may actually not call forth the same patriotic fervor those fries once commanded. Just saying – maybe Poland needs better advice on its PR efforts.

Anyway, there is a difference between the EU's sanctions and Russia's. Most of the sanctions imposed by Europe hurt domestic EU producers, but not EU consumers, at least not directly. Putin's diet decree also hurts selected EU producers, but apart from that, it hurts Russian consumers as well. There is a whiff of mercantilist thinking about it in other words. 


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The Big Freeze

Here in France, the weather has turned bad. It is rainy and cold, with the temperature below 60 degrees. Our thoughts turn gloomy… we give the cat some extra food.

“It seems to be happening all over the whole world,” said a friend. “The climate is changing. Here in this part of France, it used to be reliably sunny and warm in the summertime. Now, you never know what you’ll get.”

Some people believe the “global warming” hypothesis. Others are convinced the globe is cooling.



A glimpse of the future?

(Photo credit: Pierre Alain)


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Political Troubles in Bulgaria

We have previously written about “Bulgaria's Strange Bank Run”, but is appears the saga is not quite over yet, so we are providing an update on the  developments since then. Keep also the curious temporal synchronicity with the most recent developments in the South Stream saga in mind. We have wondered if there could be a connection between these events. We don't know obviously, and have as of yet not seen the possibility mentioned anywhere. It wouldn't surprise us though.

There have been extensive protests against the government of technocrat Plamen Oresharski in Sofia in 2013 that were originally triggered by the appointment of Bulgarian media mogul Delyan Peevski to the post of chief of the National Security Agency. The parliamentary debate on his nomination reportedly took a mere 15 minutes. The protests then forced the government to fire Peevsky from his post again a month later (officially, he withdrew voluntarily). However, the protests still continued thereafter.



Protests against the appointment of Peevsky as head of the State Agency of National Security began in Sofia in mid 2013. The demonstrations had been organized via Facebook. A number of academics declared themselves appalled at the anti-communist slant of the protests. For instance, the chairman of the Institute for Modern Politics, Borislav Tsekov, reportedly deplored the "primitive anti-communism" espoused by the protesters. However, there also were rumors that the usual suspect Western NGOs were behind the protests. The demonstrations curiously dwindled right after the government indicated it would greenlight the construction of a nuclear power plant by Westinghouse. This has subsequently indeed happened (see the preceding article on South Stream).

(Photo via Wikimedia Commons, by AlexaHR)


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Going for the Billions


I wanna be a billionaire so f**king bad

Bruno Mars


On Wednesday, the Dow rose 91 points. But markets are generally sluggish. It is vacation time. People have better things to do than watch Bloomberg terminals and bet on stocks. So, let us also turn our attention to other things. Specifically …




How to get your share of the pot!

“Would you like to make a billion dollars?” begins an email from an old friend. He was completely serious.

“I don’t know if you’ve been following the development of the medical marijuana business in Colorado, California, Washington and elsewhere. But this much is clear – it is fantastically lucrative.”


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The South Stream Pipeline

There may or may not be a connection between the wrangling over the South Stream pipeline and the strange case of bank runs in Bulgaria (which has reportedly a very well capitalized banking system), but there is at least an odd synchronicity of these events in terms of their temporal sequence. Let's begin with a brief time line:

June 7, 2008, around noon, Brussels:

The Right Honorable Baroness Ashton of Upholland, currently serving as the High Representative of the European Union for Foreign Affairs and Security Policy, is sitting in her office, looking out of the window into the cloud-covered Brussels skies, contemplating the big problems of our time, which she and her fellow bureaucrats have set out to solve. Suddenly the phone is ringing, interrupting her reverie. She picks it up.


“Hello, who is this?”

“Hello Catherine, it's Plamen”


“Plamen. Plamen Oresharski, you know, the guy from Bulgaria? Prime minister, EU-approved technocrat?”

“Oh, Plamen! Of course! What can I do for you?”

Oresharski clears his throat.

“John McCain is coming to visit us tomorrow.”

There is a pregnant pause. Finally, Ashton whispers:

“That's terrible. Gosh.” 

“You know what some people call him? The angel of death. I think of it more as a visitation than a visit actually.”

“Don't you worry Plamen, they only call him that on tinfoil hat conspiracy sites. Nothing bad is going to happen.”

“If you say so.”


Oresharski doesn't sound convinced.


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Most Dangerous Zombies?

A regular reader writes in. The bone he picks concerns our definition of zombie:


Your definition of ZOMBIE is WRONG. A ZOMBIE lives on the back of someone else and is not productive (he consumes more than he produces).

This is true in PRIVATE and PUBLIC BUSINESS.

Zombies in the private sector are the most dangerous.


Most dangerous?

Probably not. There are plenty of zombies in the private sector. But they are usually unarmed. It’s the armed zombies that pose a risk to your life as well as your money.


Zombie Jobs Program

Still, there are plenty of zombies in the private sector… and the semi-private sector. From the Wall Street Journal:


“US Postal Service Posts $1.96 Billion Loss in Third Quarter

The agency boosted revenue by 2% to $16.5 billion in the period ending June 30. The improvement was due mainly to growth in its package-delivery business, which saw revenue rise 6.6% to $3.19 billion as postal customers increased their online spending. The service’s operating expenses rose 9.2% to $18.42 billion, as compensation and transportation costs grew.”


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THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future