The war on savers and how it damages the capital structure

Boosting 'aggregate demand'

To no-one's surprise, the Federal Reserve's open market committee (FOMC) , slashed interest rates to near zero in December, while simultaneously announcing its intention to engage in even more interventions in the credit markets, that essentially amount to what is known as 'monetization of debt', whereby the Fed buys up debt securities in exchange for newly created 'money'.

The following statement accompanied the Fed's action:

The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent. 
Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.  Financial markets remain quite strained and credit conditions tight.  Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably.  In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.  In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. 
The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.  As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant.  The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.  Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.  The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco.  The Board also established interest rates on required and excess reserve balances of 1/4 percent.

Take note of the sentence I have bolded in this statement from the money Kremlin:

„The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.“

Apparently, the Fed's central money price fixing committee holds that the way toward 'sustainable economic growth' is best fostered by making war on all of those who have refused to partake in the recently burst bubble – those that have been prudent and have accumulated savings.
It has just slashed their income by another ¾ – 1% to virtually zero, in the hope that this low rate of interest will induce them to spend their savings – in short, it intends to spur consumption by waging war on savers.

It is also hoped, judging from the statement, that consumption will be boosted by inducing the banking system to lend more money at favorable rates. The banks are large holders of the types of securities the Fed intends to 'monetize', and the Fed obviously wants to stuff them to the gills with 'new bank reserve assets' , to give them incentive to lend and get that darn money multiplier pointing up again.


A picture of monetary erectile dysfunction:
The famed 'money multiplier' – measured by dividing the money measure M1 through the monetary base. Since M1 measures inter alia the creation of new deposits (an indirect measure of the proliferation of fractionally reserved credit), the recent plunge in the multiplier indicates that the Fed's pumping up of base money has not had the desired effect. Click on chart for larger image.

The erroneous beliefs these actions are based on represent a sort of economic superstition. The idea that we have a 'deficiency of consumption' flies in the face of common sense, since common sense alone tells us that prior to the recent bust we had too much consumption – much of it financed with the same credit out of thin air that the Fed so desperately wants to get flowing again - and that this surfeit of credit based overconsumption is what has actually caused the bust in the first place.

So how come the money Kremlin believes more of the same will be a good thing?
Their error is in believing that the state of affairs prior to the bust was 'good', and thus should be recreated at all costs.
Was not the period now fondly remembered as the 'good times' – the boom – marked by lots of consumption? Yes, it was. Therefore, so they apparently hold, one should strive to once again put in place the set of conditions that seems to be the proper backdrop to 'good times'.

As I have mentioned previously, the people responsible for these decisions base them on a very simple circular flow model of the economy consisting of 'aggregates' that can be neatly pressed into equations. Drop some new fiat money into someone's lap, and presto, consumption will be revived, and with it 'sustainable growth', so their economic models tell them.
What they fail to consider is the economy's capital structure. To them, investment and capital are just another 'aggregate' , that sits somewhere in their circular flow model. 'Boost demand', so their thinking goes, 'and the rest will take care of itself'.

Unfortunately, it is a whole lot more complicated than that. If all it took to create 'sustainable economic growth' were the throwing of a few levers by a bunch of monetary bureaucrats, Zimbabwe under Dr. Gono's wise monetary leadership would be a utopia of riches. Surely no-one can possibly doubt his credentials as an accomplished inflationist. He has done a lot more to 'boost aggregate demand' than the FOMC has gotten around to so far, so it is only proper that we ask how his country ended up with an 80% unemployment rate. There has to be a fly in the ointment somewhere.

The structure of production, savings and interest rates

To the average mainstream economist, capital is merely an aggregate ; if that were actually the case, then the conclusion that lower consumption will necessarily lead to recession and unemployment would be correct.

However, there is in reality a trade-off between consumption and investment. Let us consider a world without interfering central planners.
In such a world, savings are simply that part of production that has not been consumed. Since investment is constrained by the amount of available savings, it follows that less consumption is the prerequisite for more investment.
Every year, a certain amount of capital needs to be replaced. The amount of savings in excess of this replacement need is what is available for additional, net new capital investment. Keep in mind that we are talking about real resources and capital, not 'money'.

Capital is however not an amorphous aggregate. It has a structure – what we will refer to as the 'structure of production'. This structure has a complex inter-temporal ordering; before a consumer good hits the shelves at Wal-Mart, it goes through number of processes , the stages of production.

Consider a relatively simple good like a toaster. It has metal and plastics parts, put together in such a way as to make the toasting of bread possible. In the early stages of production, the metal needs to be mined and smelted; the oil needs to be pumped and transformed into plastic. In the next stages the metal and plastic must be shaped into the various parts that will make up the toaster. In a still later stage, the parts need to be assembled. In the final stage, wholesalers and retailers hold an inventory of toasters and organize their distribution to consumers (this is a very simplified version of the whole process for the purpose of discussion – consider e.g. that the shaping of parts requires dies and molds, the production of which is quite a complex process as well).
If we consider the various stages of production involved in making this toaster, we can see that some of them must take place earlier in time than others, and that the earlier stages in which the higher order raw and intermediate goods are produced are likely to involve very long range planning and large capital investment.

So how will entrepreneurs know how much and in which stages of the production process to invest? Obviously this will depend on the amount of funds available for investment – i.e. the amount of available savings. The market signal that indicates whether a relatively large or small amount of savings is available is the prevailing interest rate.
We are all producers, consumers and savers in personal union; our propensity to collectively either consume more in the present, or consume less in the present in order to save for future consumption, is referred to as 'time preference'.

If our time preference is low, we will tend to save more of our production, which will increase the amount of savings available for investment – the interest rate in this case will fall. This allows the long range planning of consumers (saving for future consumption) to mesh with a corresponding long range planning of producers – as the larger amount of available savings as indicated by low interest rates makes very complex long range investment projects possible. Investment will then increasingly gravitate toward the earlier stages of the production structure, and these stages will then be able to outbid the later stages for labor and resources.
In addition, the production structure will tend to lengthen – a more complex and roundabout production process will evolve, adding new stages of production to the structure , improving overall productivity via increased specialization.

At the end of this process, over time, more consumption will be possible than would otherwise have been the case, i.e. if fewer savings had been available earlier. In short, by people deciding to consume less in the present and save more for future consumption, more investment is made possible, which in turn will enable more production and consequently make possible more consumption in the future.

This is what 'sustainable' growth actually is. There is no need to interfere with this process – it will spontaneously order itself in an optimal manner if left alone – by what Adam Smith called the 'invisible hand'. The sum of all individual decisions in the market economy – individual decisions that are all aiming for one's material betterment – will spontaneously create the order that makes such betterment actually possible.

By means of rising and falling interest rates, the market informs investors and entrepreneurs about the size of the subsistence fund available to finance capital investment projects, the preference for consumption relative to saving, and will thus guide the decision-making process regarding in which stages of the production structure to predominantly invest.

This also illuminates why Keynes' so-called 'paradox of thrift', which holds that a collective propensity to save more and consume less is a negative development for the economy, is wrong.
It fails to consider that only by saving can one invest – and that a propensity to save more will only affect investment in the later stages of production.
If the cycle of inventory build-up and liquidation and bidding for labor resources at retailers were the only measure of the economy's health, then we might agree with the 'paradox' – but not otherwise.

How the central bank distorts the market process

Consider now the populist policy of artificially holding interest rates as low as possible that is employed by the central bank. As noted in the introductory paragraph, low central bank interest rates are designed to artificially inflate credit and thereby stimulate consumption.

This has two simultaneous effects that conspire to create an artificial boom that must perforce give way to a bust at a later stage.
For one thing, it creates an incentive to consume rather than save – i.e. it raises time preferences. This raising of time preferences is not only due to the rising availability of credit and the lowering of returns on savings, but also due to the devaluation of money that the central bank's policies engender over time.

Normally, rising time preferences would tend to drive up the rate of interest, as fewer savings, and thus fewer funds for lending, are available. However, the rate of interest has been artificially fixed by the central bank, which then supplies as much money to the marketplace as is demanded at its prevailing administered rate. Contrary to real savings, this is however 'money out of thin air' – no production preceded its introduction to the marketplace.

At the same time, it won't fail to transmit the information to investors and entrepreneurs that there are plenty of savings available to invest.
In other words, the artificially low interest rate misleads investors into assuming that the pool of available savings (the pool of real funding) is much larger than it actually is. Large long lead investment projects in the earlier stages of production will be undertaken, just as consumers are actually saving less and consuming more due to the same artificial incentive.

For a time, the central bank can 'paper over' the fact that real resources are consumed instead of saved, but this process of 'papering over' actually accelerates the decline in the pool of real funding via overconsumption, while capital is concurrently misdirected and malinvested. This process of malinvestment can also be described as an intertemporal discoordination of the production structure, as too much capital flows toward the production of early stage higher order goods production.

This combination of overconsumption and malinvestment takes place until the point in time when the actual state of the pool of real funding is suddenly revealed.
Malinvestment implies that numerous investment projects were started that could not possibly be finished, respectively also that numerous economic activities were underway that would not be viable at all absent a credit boom.

Sometimes the artificial boom ends because the central bank belatedly decides to abort its artificial low interest rate due to the secondary lagged effect – rising prices – becoming 'visible in the data'. As an artificial boom-bust sequence progresses, it takes more and more credit inflation to engender the 'desired' economic effect of 'creating growth', which is really synonymous to creating economic activities that squander wealth. At the same time, it takes an ever smaller rise in the administered interest rate to actually starve the boom of the exponential credit creation it needs to survive.

The duration and amplitude of the boom-bust sequence meanwhile increases over time, as more and more of the pool of real funding is consumed. How can there be a 'boom' at all, when it consists mostly of overconsumption and malinvestment? Simply put, the artificial boom that credit and money out of thin air create draws upon the previously accumulated capital and consumes it, or part of it.

Note that there comes a point in time when no amount of additional credit out of thin air can restore the boom – this final stage is reached once the credit expansions of the past have consumed so much of the subsistence fund of real savings that it has stopped growing, respectively has actually begun to decline. The current 'credit crunch' episode is a strong sign that we may have reached that point.

How can we measure the increasing amplitude of the boom-bust sequence over time? This can be done by observing the ratio of the stock market to real money, i.e. gold.
Stephen Fairfax has written a brief article on the topic , entitled 'Out of Control: Recognizing Instability', which is a highly recommended take on the subject.

Although the pool of real funding is not directly measurable, a good indicator of its state is likely how the stock market reacts to monetary pumping. Normally the stock market is very sensitive to decreases in the Fed's rate of interest. When it fails to react to numerous rate cuts, we have a strong indication that something must have gone wrong on a very fundamental level – this fundamental level is the economy's production/capital structure and the pool of real funding.

Considering the fact that the the Dow Industrials Average has declined by almost 80% vs. gold and that the stock market has rarely – no, never – reacted so negatively to a major rate cut campaign (the stock market has never before experienced a one year decline as steep as in the one from its October 2007 high), we can conclude that a major failure of the 'money and credit out of thin air' experiment is in train.


The Dow-Gold ratio. Since the Federal Reserve was established, the oscillations in this ratio have become bigger and bigger. This is a good proxy for the boom-bust cycles engendered by fractionally reserved fiat money expansion. An additional note: should the stock market reach its putative target in real terms, there will have been no progress in real stock market value at all since the turn of the century; this contrasts with the time period prior to the establishment of the central bank, when the Dow-Gold ratio consistently rose in a relatively tight channel. This is to say, the stock market rose in real terms from 1790 to 1920 in said channel, until it broke out of it in the first artificial boom-bust sequence of the 1920's and 1930's. Ever since it has gyrated wildly. Click on chart for larger image.
chart via Fred's Intelligent Bear site.

The Bust – its function and why it should not be fought.

There is great incentive for the political class and the monetary authorities to be seen to 'do something' in the face of the developing bust. So they go forth and 'do something' – with nothing even remotely resembling a plan (although they are central planners, they do not even possess a plan – as evidenced by the ad hoc changes to various interventions to date and the continual piling on of new ones).
The public expects them to do something, in a mistaken assumption that they are actually able to avert or alleviate the bust. As I have said before, we should judge them by their results, which so far are sobering indeed.
As Bob Hoye has mentioned in this context, if it is true, as the interventionists contend, that their actions 'will only be felt with a one to two year lag', then one might well ask what they were planning for one or two years ago. A crash?

Let us consider for a moment in the light of the above excursion into capital theory what the root cause of the bust is – it is the preceding artificial boom. It felt like 'good times', but in reality it was an illusion. We certainly did not create a better economic production structure that will enable us to consume more in the future.
On the contrary, capital was malinvested on a truly momentous scale (as a look at current housing inventory easily demonstrates) , and quite apparently, this happened worldwide.

We did not save enough, as countless 'nay-sayers' warned - here, and here and here - while being ridiculed by the gaggle of courtier 'experts' and pundits, who to a man turned out to be wrong .
The bust is naturally painful – in fact, it's a good bet that the bust now underway will be very severe in terms of rising unemployment , falling industrial production, and other statistics describing the level of economic activity.

Think for a moment what a herculean task the economy now has to perform – the production structure must be considered to be severely out of whack, now that it has turned out that the pool of real savings is much smaller than previously thought.
Thus malinvested capital needs to be liquidated, and where possible redirected. Many investment projects in earlier, higher order goods production stages have been, or will still have to be, abandoned.
Savings need to be rebuilt, so the later stages of production are and will be exposed to a sharp decline in consumer demand.
The amount of labor needed to repair the capital structure will perforce be much lower than that likely to be employed when everything is running smoothly.

So there simply is no way this can be done painlessly. The mistakes of the boom can not be 'unmade' – the houses no-one needs, the shopping malls no-one needs, the factories producing cars that no-one wants, and the capacity in earlier production stages supplying them – it all has been built already. Creditors have lent money they will never get back.
The boom created both economic activities that were entirely artificial and consumed wealth (such as the surfeit of real estate agents in California, for instance) as well as misdirecting capital to the 'wrong' portions of the production structure , so we can also conclude that other, more worthy economic activities were deprived of capital – after all, the pool of real funding is finite. It will take time to redirect capital toward these activities, so one must allow for a period of sub-par economic performance until this process is completed.

The best we can hope for is that we get it over with as quickly as possible – but that is precisely what the interventions are unwittingly designed to prevent. We need more savings and less consumption for a time – which the Fed discourages by pushing rates to zero.
We need the private economy to have full access to the available resources at the right price. Instead we have the government 'crowding out' private borrowers by engaging in huge deficit spending. This spending must be financed from existing resources, but it can not possibly be a 'better' use of scarce capital - on the contrary, it will lead to more misdirection of resources.

In this context, note that the much higher interest rates that now e.g. prevail in the market for corporate bonds are a step in the right direction. Given that the risks of lending have risen and savings are scarce, the best way to draw new savings into the marketplace is by offering interest rates that compensate for these higher risks.

Meanwhile, the government and the central bank are trying to keep the 'something-for-nothing' scheme going that has led us to this juncture – the bust – in the first place. It will unnecessarily delay the economy's healing process, and this is no small matter, as one can easily ascertain when looking at Japan's two 'lost decades' or Hoover's and FDR's Great Depression.

In the whole world I have found precisely one mainstream politician in a position of political power (although he will find out that his position is a lonely one indeed, even in his own government's cabinet) who publicly speaks out against the folly – German minister of finance, Peer Steinbrück.
In reference to Gordon Brown's most recent economic insanities, Mr. Steinbrück remarked in a Newsweek interview:

“All this will do is raise Britain's debt to a level that will take a whole generation to work off.”...”The same people who would never touch deficit spending are now tossing around billions. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn't this the same mistake everyone is suddenly making again, under all the public pressure?”
“It's the yearning for the Great Rescue Plan. It doesn't exist. It doesn't exist!”

Even if it is only a small consolation, there is at least one major political figure in a Western industrialized nation who does not seem to subscribe to interventionist voodoo economics. Funny enough, he's a member of the German Social Democratic Party. Paul Krugman doesn't like him, which counts as indirect confirmation that Steinbrück must be 100% correct.

Before anyone gets too excited, here is what Brown had to say by way of riposte:

“Mr Brown, who will head to Brussels later today, reiterated that "every country around the world" agreed with him.
He told LBC Radio in London: "Actually, the German Government is investing more. They have just announced a fiscal expansion so that they can invest in public works and helping their banks and doing these sorts of things. "I do not really want to get involved in what is clearly internal German politics here, because they have a coalition in Germany with different political parties. "The important thing is that almost every country around the world is doing what we have been doing." Not taking such actions would mean "failing in the role of Government", he said. (my emphasis).

Clearly there is little reason for hope, because what Brown says is true – virtually every government in the world has adopted the deficit spending and rate cutting malfeasance that has demonstrably failed every time it has been tried.

Ergo, get ready for a long, hard slog.


Interventionist Brown, crisis-stricken


Doubting Thomas: Peer Steinbrück


Interventionist Bernanke, pre-crisis


Interventionist Bernanke, crisis stricken

We are not 'all dead in the long run'

1. The long run becomes the here and now

In response to the classical and Austrian critique of his advocacy of state intervention in the economy, J.M. Keynes once uttered the following 'witticism':
'In the long run we are all dead'.
The criticism was that government intervention , while possibly capable of alleviating the short term pain of economic downturns for a while, was apt to store up ever bigger problems for the long term.
The government could 'paper over' economic crises up to a point by attempting to resurrect an inflationary boom with interest rate cuts and deficit spending, but this would distort the economy's production structure further, until at some point in the future, an economic bust of exceedingly great magnitude would inevitably ensue.
In short, payment for foolish economic policies could not be delayed forever; the damage done by government's tinkering with the economy would eventually be revealed.

Today, we seem to have arrived at the point where the heretofore mythical 'long run' has suddenly transmogrified into the all too real 'here and now'.

Our once vaunted banking system is on the brink of insolvency, and economic activity has begun to contract at a speed and ferocity that has not been experienced in at least 28 years, threatening to get even worse. That episode of 28 years ago, mind you, was coupled with a deliberate and extreme tightening of central bank policy intended to rein in run-away inflation. This stands in stark contrast to the current 'zero bound' monetary policy along with both the biggest Fed balance sheet expansion and the speediest expansion in base money ever.

J.M. Keynes is indeed dead; we, alas, are still alive - reaping what he helped sow.

2. Deceptive stability

Central planning of interest rates combined with the occasional fiscal bail-out or stimulus scheme has for some time now been believed to have brought about the elusive goal of 'economic stability'.
Who does not remember the gushing over the 'Maestro' Alan Greenspan and his 'when in doubt, cut interest rates' policy, once dubbed the 'Greenspan put' by stock market traders?
In reality, Greenspan lent a helping hand to the creation of the biggest credit bubble in history , all the while lulled into dangerous complacency by the seeming 'absence of inflation' (this is to say: the absence of sharply rising prices for goods and services – asset prices 'inflated' willy-nilly of course).

It got little notice at the time, but sometime in the mid 1990's, the fractionally reserved banking system got a big additional shot in its happy-go-lucky inflationary credit expansion arm, when the Federal Reserve decided to tolerate so-called 'sweeps', whereby banks would sweep monies from demand deposits into 'zero interest bearing CDs' overnight, letting demand deposits masquerade as savings deposits. Since savings deposits require far lower reserves than demand deposits, such reserves were then freed up to inflate credit further.
Not coincidentally, it was around this time that broad money supply measures began to go parabolic, along with the ratio of total credit market debt to GDP (or the ratio of total credit market debt to any other yardstick one was inclined to compare it to, from personal income to corporate profits to, you name it).


Money of zero maturity, a broad money supply measure. click on chart for larger image.

For many years, a falling savings rate and a concurrent sharp rise in consumption-related debt was rationalized away by mainstream economists. Absurd increases in first share prices and then house prices were considered to represent 'an increase of wealth' , which had magically replaced the need to actually save.
There was no need to worry about the growing mountain of debt, they would say; after all, you only needed to look at the other side of the consumer's balance sheet, where all that 'wealth' had piled up, as if houses and stocks had been watered with 'super-gro'.

Here and there a party-pooper would ask, yes, but what if these elevated prices were to fall one day?
Such objections were routinely shouted down : Can't happen! It has never happened! House prices always go up! And so do share prices, in the long run.
They do? But.....aren't we supposed to be 'all dead in the long run'?

All of a sudden, this seeming 'permanent plateau of prosperity' and growing phantom wealth has given way to one of to the greatest bouts of economic instability in living memory, and – oops! – house prices are falling, and so are share prices – with over $30 trillion in stock market capitalization having disappeared globally.
The balance sheet looks all bent out of shape now, as the debts remain big as ever and are going sour at a rapid clip, taking down lenders and borrowers alike.


3. Keynesian policies come natural to politicians

It is only natural that politicians have eagerly adopted Keynes, and that consequently, the entire establishment has eventually sanctioned his theories to the exclusion of nearly all contrary ideas.
To become a member in the 'pantheon of establishment-approved economic theorizing' you have at the very least to be a Keynesian-in-drag, as in for instance, the form of a supply-sider (the moment you raise the slightest doubts about the need for central planning of money and interest rates, you instantly become an irredeemable pariah in the economics profession).

Note that Keynes did not come up with any radical new ideas – he basically adopted and adapted the ideas of German socialists, who had long before him advocated massive state involvement in the economy. His main achievement was to give governments around the world a philosophical/pseudo-scientific fig leaf for pursuing exactly the policies they always wanted to pursue.

The political life-cycle is partly to blame . If one's main job is to get as many votes as possible in the next election, one can hardly be expected to worry about the long term impact of one's economic policies – especially given the fact that due to the lag times involved , few people actually realize how cause and effect are related in economics.
Furthermore, the contingent of the citizenry interested in growing the power of the state grows along with the state – and if one thing is absolutely certain, it is that a true 'laissez-faire', free market oriented policy is not conducive to the growth of the state.

Nowadays there seems to be a growing consensus that Greenspan's attempt to inflate away the last big bust is partly responsible for our current dilemma.
And yet, what is being done to 'fight' the current bust? Don't look now, but they're doing exactly the same thing again ,only bigger.
This, in a word, is insanity.

Naturally, one had to be truly comatose not to realize that Greenspan's 1% Fed Funds rate helped to ignite the mortgage credit bubble and the associated bubble in real estate prices, so it's not as if this represents a great revelation – what is interesting is only that it is being discussed in the media at all.

The most recent glimmer of hope on that front came from an unexpected source – the chancellor of Germany, Angela Merkel.

To the aghast invocations of imminent doom from interventionists around the world were she not to recant immediately, or even better, retroactively, she recently defended Germany's decision to refrain from joining the global 'stimulus package' orgy whole hog thusly:

“Excessively cheap money in the US was a driver of today’s crisis,” she told the German parliament. “I am deeply concerned about whether we are now reinforcing this trend through measures being adopted in the US and elsewhere and whether we could find ourselves in five years facing the exact same crisis.”

One can imagine the reaction of the menagerie of bail-out clowns – what? Five years? That, in terms of the political life cycle, is the 'long run' in which we're allegedly all dead. It is definitely further away than the nearest election. Such a daring look beyond one's own nose is considered impolitic.

(it must be noted though as an aside that Mrs. Merkel is very reticent to lower taxes, as demanded by Mr. Seehofer, leader of the CSU, a party allied with her CDU; just to make sure there's no misunderstanding: I'm not a big fan of Mrs. Merkel – i merely note that it is a hopeful sign that an establishment figure of her stature speaks out critically on the money pumping issue. It may have to do with Germany's socio-economic memory – the inflation of the Weimar regime and all that flowed from it is embedded in the German psyche as a deeply negative experience).

4. What to do, and what to hope for

As an individual who understands the current situation one can only watch with growing dismay and desperation as governments the world over are practically falling over each other trying to repeat Japan's mistakes of the 1990's, and Hoover's and FDR's mistakes of the 1930's. It's almost as if there were some sort of competition on about who can implement the most insane and costliest 'solutions' from the interventionist cook-book in the fastest and most grandiose manner.

There is little to no chance that governments will suddenly get free market religion, short of a collapse so total that they are wiped out in a collective global bankruptcy. Mind you, we should not necessarily wish for that, for a number of reasons (more on that will follow in a future blog).

Current events have a certain deterministic quality – more intervention is certainly on its way , and so is its long term result, economic depression – one can only try to prepare for it on a personal level, on the general principle that one should hope for the best and prepare for the worst.
Do not count on government promises to bail you out when push comes to shove – unless you're a Wall Street banker, chances are your role will be that of a cow to be milked. A paymaster who has no say in the proceedings (since there is no-one you can vote for who is not in principle aboard with the interventionist schemes).

So what can we hope for? It's a fairly distant hope, mind you, but it's always possible that Keynesian interventionism ends up discredited in the public's eye, on account of its assured failure.
One should not let an opportunity pass to discredit it. In economic matters, the press is unfortunately positively infested with statism, and that includes most of the so-called 'conservative' press.

In fact, i have been quite dismayed when at a recent hedge fund conference in Vienna a bunch of professional investors likewise loudly proclaimed their economic ignorance by demanding more government intervention!
A professor of economics who somehow had found his way to the conference was found singing from the same hymn sheet; one thing he said is worth mentioning:
The authorities, he averred, must engage in just the right amount of monetary and fiscal pumping, i.e. not too little, but also not too much , to keep all sorts of unintended consequences from rearing their head.

Full stop. Let's point out what should be obvious:

They always have this problem, and it is exactly the same problem that the Soviet Union's GOSPLAN agency had when it tried to determine how many nails, screws or hammers it should produce - a central planner can never know what the 'just right amount' should be – this is precisely why we're in the trouble we're in now!

The only possible solution to the crisis is not intervention, it is also not more, or faster, or 'better' intervention – it is to do nothing.
Let the market fix itself.

5. Judge them by their results

Yesterday, Bern Bernanke held a speech at the Austin chamber of commerce, that received some attention as he basically announced that the Fed was about to go down the 'quantitative easing' path in earnest.
A J.P. Morgan economist, Michael Feroli, promptly christened him 'Bernanke-san' in a research note.
From the Bloomberg article on the speech:
"„One option is for the Fed to buy “longer-term Treasury or agency securities on the open market in substantial quantities,” Bernanke said. “This approach might influence the yields on these securities, thus helping to spur aggregate demand.”"

Why would anyone want to 'spur aggregate demand?' Oops, i forgot – our monetary crank-in-chief is a dyed-in-the-wool Keynesian. He actually believes there's something wrong with demand all of a sudden. It's, don't you know, an 'animal spirits' induced calamity that has befallen consumers. The very people who normally are insatiable, are now mysteriously 'demand deficient'.

The economic model on which this notion is based has absolutely nothing to do with reality - it assumes that goods for consumption can somehow be plucked from a tree, if only they are 'demanded'.
Just drop some cheap fiat money in someone's lap (if necessary, from a Friedmanite helicopter, so that that someone goes to Circuit Ci..,err, Best Buy, where he then demands his third plasma screen , even if he doesn't need one. Presto, demand deficiency problem solved, the economy is healthy again!

Good grief. It might work if we could get something for nothing, but alas, not otherwise.

The markets greeted the Bernanke announcement thusly: the already severely dislocated government bond market (which recently has made a parabolic move in the wake of the Fed announcing that it would buy up $800bn. in MBS and ABS) continued to blow off – and the S&P index , for want of a better word, crashed by 8,9%, with financials in the index getting crushed by 17% - their biggest one day decline ever.

Bernanke, the alleged expert on the Great Depression (all the books worth reading about that time have apparently managed to escape his attention), presumably knows what government bond yields did in that period; or what they did during Japan's slo-mo depression of the past 20 years.

Did it help? Was 'aggregate demand spurred'?

In the q&a after the speech the depression actually was talked about. Bernanke sotto voce announced his firm belief in the conceit that has befallen just about everyone: namely that policy makers would 'of course not repeat the mistakes that were made then'.

This is what contemporaries have always believed of the interventionist institutions of their day whenever a bust started to unfold. In 1873, the powers of the treasury secretary – who surely had a plan – were believed to be capable of averting the calamity – a 20 year long depression promptly ensued.
In 1929, the Fed was firmly believed to be able to avert the downturn - after all, this institution with its 'flexible currency' built on sound scientific principles could not possibly fail at the task.
Well, they believe it again. You could say, Bernanke actually believes his own bullsh*t.

Not only is he already repeating all the mistakes made back then, he has already made new ones on top of them, and is set to make even more. The difference is only in the details, not in the substance. He is doing what the Fed did in the 1930's, only on a much grander scale. Why anyone would expect a different outcome will remain a mystery for now, but you can be sure that there will be no shortage of excuses.

Let us briefly look at the result of the interventions to date. After $8,5 trillion in bail-outs and bail-out pledges , we have:

the biggest one year decline in the stock market in all of history; the biggest decline in real estate prices since the great depression; a complete collapse of the structured finance market; an economic contraction that is so fast and deep that it promises to make the history books as one of the worst on record.
(we are showered with scary economic numbers from all over the globe daily, but just to name one example illustrating how big the catastrophe already is: the Baltic Dry index that measures international shipping rates has suffered a 95% plunge from its highs).

This is what we've got so far, for a $8,5 trillion price tag. Not exactly a satisfactory result you say? You bet.

Due to the ad-hoc manner in which the interventions to date have been implemented (whereby the Fed and treasury seem to be constantly trying to outrun a widely feared implosion of the otc derivatives markets), a great deal of uncertainty has been imparted to the markets. Of the 'what will they think of next'? type. The whole process lacks both predictability and credibility, as Linda Rowley notes in an excellent article here.

A final note: the downturn is the end result of the previous boom. The biggest credit and malinvestment boom ever, as one must keep stressing. There is no way of averting or avoiding the bust. It has to happen. It may be painful, but underneath the pain, the economy is actually healing and repairing itself. It makes no sense to intervene, as every attempt to avert the bust will only delay this healing process.
Anyone with an ounce of common sense should be able to see that an artificial lowering of interest rates in order to 'spur demand' and 'spur lending' can not be the proper cure for an economy groaning under the weight of an imploding credit bubble, where many are already up to their eyeballs in too much debt.

Given the fact that the bust can not be averted, our societal goal should be to see to it that it passes as quickly as possible, without fresh malinvestments being added atop the old ones.
This can only be achieved if government keeps its hands off the economy. Bernanke's idea to suppress interest rates across the yield curve is completely useless voodoo-economics trash, to put it politely.
It has all been tried before and it has never, ever helped, and never will.


Voodoo economist Bernanke


...and 'We're all dead in the long run' Keynes, the man whose prescriptions governments keep following religiously, in spite of incontrovertible evidence that they have always failed. They don't work in practice, because they don't work in theory either.

Why the stock market keeps plunging

The mortgage debt crash continues with abandon

This is a brief update to what i wrote on the week-end about the growing dislocation in mortgage backed securities - in the meantime, the situation has gone critical, so to speak.

Below are charts of the CMBX indexes, referencing AAA, A, and below investment grade (BB) rated commercial mortgage debt pools. By means of explanation, these indexes track credit default swaps on said debt, and can be used to hedge. They broadly reflect what is actually happening with the underlying debt spread-wise. When the CMBX rises, the underlying debt falls in price - in this case, free-falls.







3 different CMBX indexes, referencing CDS on AAA, A and BB rated commercial mortgage debt pools. charts via Markit - click on charts for larger images.

The following points must be considered: as this article on Marketwatch mentions, life insurers are among the biggest holders of the commercial mortgage backed securities (CMBS) that are now going sour at, well, warp speed.
Furhtermore, AIG's ill-starred portfolio of CDS (recall that AIG was a writer of these swaps, so it is located at the losing end of these trades) reportedly has a lot of MBS exposure in one way or another (partly one more step removed, via having insured CMO tranches for instance, i.e. CDO's containing MBS), and the government can hardly stop with its bail-out of AIG now, even in the event of it growing even larger.

Since we don't know what steps AIG might have taken to e.g. hedge its remaining exposure, the bail-out loan may or may not grow immediately, but i suppose we shall find out soon.
However, even if AIG has hedged in the meantime, it means that whoever wrote that insurance is now commensurately underwater.

CDS on corporate debt follow suit

As the Wall Steet Journal's Marketbeat column notes here, as an extension of the trouble at the mortgage end of the credit markets, indexes tracking CDS spreads on corporate debt are also blowing out once again as well, back to levels that have last been seen in the wake of Lehman's demise.

I distinctly remember having read that someone with the Bank of England - unfortunately i don't recall who it was - described the October episode thusly: "We were 24 hours away from a complete systemic meltdown".
Not exactly a comforting thought.

Car maker debt crashes too

As is often the case with such situations, the panic-inducing events suddenly proliferate. Today the market also had to grapple with Congress playing hard-to-get with the 'big three' car makers, whose CEO's had flown in (in their private jets, no less) hat in hand to somehow unlock $25 billion in aid. In order to do so, they painted a suitably scary horror-scenario (see this post for what it consists of), but found a surprisingly unsympathetic Congress grilling them rather unmercifully with regards to their lack of qualifications to see the industry through this patch of crisis.

This promptly added to uncertainty in the junk bond markets, where the debt of the car makers makes up the vast bulk of all junk debt issued. Marketwatch notes today that
"Bonds issued by Ford Motor Co. (F: 1.26, -0.42, -25.0%) and General Motors Corp. (GM 2.79, -0.30, -9.7%) have been trading well below par value, at about 25 cents for every dollar invested, down from about 75 cents to 80 cents a year ago.".

again, not exactly comforting.
On Monday, CDS spreads on GM's debt had already risen to about 7,200 basis points (!), with Ford's not far behind at 6,300 bp's.

My guess: while Congress seems none too happy about the car maker bail-out request, the 'tough talk' could easily be just for show, similar to what we have seen on occasion of the TARP 'no we won't!' -'yes, we will!' farce. Recall that resistance to TARP largely was about adding as much pork as possible to the bill before passing it, while making it seem as if Congress worried about the backlash from bail-out-weary citizens.

As i have pointed out before, the elephant in the room is the outstanding notional amount of CDS on the car makers' huge debt. While i don't know the current amount with precision, it is a great deal larger than the underlying debt - and even though there is a lot of netting, we'd be looking at unusually large sums having to change hands at once and at relatively short notice.


An interventionist curveball smashing the windows

So we once again have a perfect storm bearing down on the financial markets - and ironically, one of the chief architects of the financial bail-out, treasury secretary Hank Paulson, got the ball rolling with his recent announcement that the treasury would after all refrain from using TARP funds to buy distressed mortgage assets. Instead, direct capital infustions into banks would be the preferred method of deploying the funds.

This initially sowed enough confusion to send the stock market sharply lower, but the market reversed one day later in what seemed to be a 'key reversal' day.
Leaving aside whether this new use of the bail-out funds is 'better' or not than the original purpose (many seem to agree that it is, but i will refrain from discussing the relative merits of interventions - they are all bad, for reasons explained previously), the market initially appeared to have changed its mind from voting 'nay' to voting 'aye'.

As so often happens, the change in course immediately set off a chain reaction of unintended consequences - which can be gleaned from the CMBX charts above.
The authorities are now akin to a single fireman running around in a burning house with a bucket of water - while he's busy dousing a pile of burning paper in one corner of the house, the fire immediately becomes more intense in another.
Given the ominous statement rumored to have come from inside the BoE regarding the October dislocations, we must now hope that the whole house doesn't inadvertently come crashing down.

The stock market once again proceeds to do the 'unprecedented'

This weekend, i presented the chart of the BKX index as one of the things that bothered me greatly (once again) about the stock market. Here is an updated version:



The Philadelphia Bank Index - the neckline of the h&s formation has broken - this looks ugly. It may rally back to the broken neckline, but a break back above it would be needed to invalidate the bearish message - click on chart for larger image

This has also led to wave 5 of 3 in the S&P index (the labeling may not be precise, but this seems to be the most obvious rough count right now) breaking below the 3 of 3 low, instead of being somehow truncated as it often - but not always - is after a crash like moves. I'm unhappy to report that one time when the 5th wave of a crash wave did clearly streak to a lower low was in 1929 (a year many people are now unexpectedly learning more about in view of recent events).



The S&P 500 says 'adios' to support - presumably this support level was just too obvious to hold. click on chart for larger image

Let me add that if this is indeed wave 5 of 3, that would mean that the crash wave will soon find its low, after which a larger (multi-week or multi-month) rebound could conceivably be expected - a large wave 4.
However, consider the potential measured move target of the BKX chart above - this 5th wave could still become rather scary - not that it isn't scary already.

Counterparty risks climb again

In view of the renewed stresses in the credit markets, we can probably conclude that counteparty risk - a problem which had been thought of as momentarily defused in view of the large decline in LIBOR that the Fed helped engineer by expanding its balance sheet into the blue yonder - is coming back into focus.

This is no small matter, as there is always a remote possibility that a large player is felled (see Lehman) and can not or will not find a bureaucrat willing to bail him out in time. This risk is now particularly acute, as the political backlash against the car maker bail-out shows.

Lastly, i leave you with a chart that should give the Bernanke-Paulson tag team at the very least a sleepless night or two:



Citigroup (C) - this is one of the world's largest banks - and its stock price is crashing, down 23% in today's trading alone. We know it had and still has vast exposure to the collapsing real estate credit bubble. This stock's recent performance gives reason for grave concern. If we are lucky it's just an overshoot tied to the general asset liquidation theme. - click on chart for larger image

charts by stockcharts.com and Markit

addendum: I should add that it is in the nature of final down waves in a crash scenario to be accompanied by a horrible news backdrop. We can be fairly certain that this is the final wave down in this paricular move - and although its extent can not be predicted with certainty, the low is probably close in time - in addtion the support level from the 2002 market lows is nearby. The move in credit spreads increasingly looks like a blow-off, which likely means it will soon pause. Having said all that, risk still appears extraordinarily high.
A slightly positive development is that some commmodity prices, including the precious metals, appear to be 'digging in' a bit of late. This is probably an early indicator of the impending market low. The dollar and the Yen - especially the Euro - Yen cross - have moved persistently in the opposite direction of the stock market. These currencies should be watched for possible divergences.