Acting Man

The potent directors fallacy

noreply@blogger.com (pater tenebrarum) — Mon, 02 Feb 2009 14:14:00 +0000

A brief look at history - the crash of 1929

September 1929 – the slide begins

After reaching its then all time high of 381,17 on September 3 , 1929, the Dow Jones Industrials Average began what was at first a fairly slow slide.
From the beginning of June to the first trading day of September, the average had gained 79 points – almost as much as in all of 1928, which was already a fairly spectacular year. Margin credit exploded during the summer of 1929 by an average of $400 million per month, then a huge sum.

There was heavy trading volume throughout the summer, with about 5 million shares changing hands daily at the NYSE, which represented about 60% of all trading volume in those days (the remainder of trading took place at the 'curb' and exchanges in other cities; curb traded shares avoided the NYSE's listing requirements).

Not surprisingly, after such a heady summer, which capped several years of steady gains, no-one thought the September pullback remarkable. After all, the market had suffered quite a few pullbacks in the course of the bull market, some of which had been a great deal more scary.
The progress during the summer months had been steady, with pullbacks mild and never lasting longer than two or three days in a row.

During September, the market's character underwent a subtle change. In the first half of the month, pullbacks still only lasted two days in a row at most, but that changed later in the month. A string of five down days in a row, then one small up day, followed by another three down days ended the month – the DJIA was suddenly back at its level of late July, having lost all the gains made in August.

An interesting feature of the summer months as well as September was the attention broker loans received. Due to the high interest rate these margin loans paid and the presumed safety of the collateral behind them, they attracted funds from all sorts of sources. Speculators in turn didn't worry about the high interest rate – a 9% annual rate could not deter someone seeing gains of 25% in a mere three months, as had happened during the summer (and of course those gains had been magnified due to the liberal use of margin).

Nevertheless, there were numerous critics expressing worries about the growth of margin lending, but the financial press tended to play their arguments down, even going as far as charging the critics with trying to undermine confidence for ulterior reasons (Barron's and the Wall Street Journal both published editorials to that effect).

Economics professors from Princeton to Yale also lent their optimistic voices in support. The main argument was naturally that stock prices were actually not overvalued; after all, prosperity was deemed certain to continue to increase. Thus the bearish argument that 'margin loans will become a problem if and when stock prices should fall' was not to be given credence, because there was no reason for stock prices to fall.

Alan Greenspan, when defending central bank inaction in the face of the 1990's bubble, was - perhaps unwittingly - going to repeat an argument first forwarded by Professor Lawrence of Princeton in 1929, in defense of the 1920's bubble.

Professor Lawrence had said:

'The consensus of judgment of the millions whose valuations function on that admirable market, the stock exchange, is that at present, stock are not overvalued. Where is that group of men with the all-embracing wisdom that will entitle them to veto the judgment of this intelligent multitude?'

Alan Grenspan's words were:

'For a central bank to identify a bubble involves pitting its own assessment of fundamentals against the combined judgment of millions of investors.'

(It is interesting to note in this context that neither Alan Greenspan nor any other central banker thinks it odd that the central bank should know better than this 'multitude of investors' at which level interest rates should be set.)

The skeptics were few, and in addition, the seemingly unstoppable upward march of stock prices served to discredit them. Banker Paul Warburg was one of the few financial professionals daring to voice doubt.
Alas, his stern warning came in March of 1929, when the market had just endured a temporary break, and the subsequent rally relegated him to the stable of 'obsolete bears'. The pessimists, it was often speculated, had financial motives for their pronouncements, such as being short the market.

It was in this spirit that the late September decline was greeted. Two days after the high print of September 3, there had been a memorable one day break of 2,6% , which later became known as the 'Babson Break'.
The multi-talented entrepreneur , business cycle theorist and investor Roger Babson, an early proponent of technical analysis, had held a speech at the Annual National Business Conference in which he boldly predicted that 'Sooner or later a crash is coming, and it will be terrific.' Not only that – he also predicted that a vicious cycle of liquidation and a serious business depression would ensue.

The financial press lost little time in denouncing him (a Barron's editorial pointed to his 'many inaccurate predictions in the past') , and Professor Irving Fisher of Yale declared a crash all but impossible.

The news backdrop deteriorated somewhat in late September of 1929. On September 20, the business empire of Charles Clarence Hatry in Britain collapsed, among allegations of fraud. It turned out Hatry had forged stock and bond certificates and cooked his company's books to boot.
His undoing was triggered by an unsuccessful attempt to merge a number of steel foundries into United Steel, which would then have emerged as one of the largest British steel producers.

The coup was too big for him, and he got caught trying to pass off GBP 1 million worth of forged municipal bonds in an effort to obtain the necessary funds. This invited scrutiny of his corporate accounts, and the Hatry Group promptly collapsed ($30 million were lost due to the collapse of Hatry shares alone).
British investors then began withdrawing fund from elsewhere, including Wall Street. This probably contributed to the 7,4% loss in the DJIA from September 20 to October 1.

Concurrently, the Federal Reserve reported a slightly worrisome deterioration in business conditions, specifically, a marked decline in industrial production.
Nevertheless, as a measure of the confidence that continued to reign during most of September, broker loans increased by a record $670 million during the month.

October 1929 – the appearance of 'organized support'

On October 3, the day the Kingdom of Yugoslavia was established by merging Croatia, Serbia and Slovenia, the market endured yet another big break. The DJIA took an near 15 point nosedive, equivalent to a decline of 4,23%. It closed at 329 points, a level last seen in late June of 1929.
No particular reason accounted for the sell-off – it simply appeared to be a continuation of the late September malaise.

No-one was worried yet however, and the market recovered in the following week to 352 points. Professor Irving Fisher achieved a dubious immortality by stating on the evening of October 15: 'Stocks prices have reached what looks like a permanently high plateau'.

October 16 was another weak day however, with the DJIA losing over 11 points. It regained about half of that loss the next day, but then came Friday October 18 and Saturday October 19.

In those days, the exchange was open on Saturdays for a shortened session. Ominously, a large price break occurred with volume the heaviest ever recorded in the short session – nearly 3,5 million shares.
The Dow lost a cumulative 18 points, or 5,26% in those two trading days – landing at 323,87 – a new low for the move.

Rumors that margin calls had gone out began circulating (the rumors were true), and the Sunday papers uneasily reported about the 'wave of selling' that had engulfed the market on Saturday.

A more reassuring note was however sounded insofar as the papers – specifically the financial press – almost all concurred that 'the worst is over'.
This was when the phrase 'organized support' first appeared. The idea was that the major banks and Wall Street houses, as well as the highly leveraged investment trusts, would not 'allow' the market to fall further.

Frequent mention was made of what we nowadays know as 'cash on the sidelines', as the investment trusts were (correctly) thought to hold large cash reserves.

Monday October 21 was an uneventful day in terms of price movement, with the Dow declining another 2,96 points to 320. However, it sported what was then the third-largest trading volume in history, 6,09 million shares.
Intra-day the market had been down a much larger 8,5 points, and due to the frantic trading volume, the ticker tape for the first time in the course of the decline failed to keep track of prices in a timely fashion.

In hindsight, this technological snag probably contributed greatly to what happened next. The problem for the many margined speculators was that they could not tell anymore where prices were at a given point in time, and had to fear the worst.
This created a 'sell before it's too late' mentality.

On Monday October 21, the tape was 1 hour and 40 minutes behind actual events. This had of course happened before, but only in a rising market, not a falling one.
The psychological difference between being late in finding out how much richer one has become as opposed to being late in finding out whether one has been ruined is considerable.

That Monday, Professor Fisher again declaimed his confidence, by stating that merely 'the lunatic fringe had been shaken out' of the market, and that stocks were now undervalued, because inter alia, they did not yet reflect the beneficent effects of prohibition, which had made 'American workers more productive'.

The chairman of National City Bank (known today as Citigroup), Charles E. Mitchell, a.k.a. 'Sunshine Charley', announced that 'the decline has gone too far' , and in a refrain familiar to the newly minted veterans of the 2008 market crash, declared that the country's 'business fundamentals are sound'.
Furthermore, the attention paid to margin lending volumes was entirely unwarranted in his opinion.

It appears that Citi has attracted 'late dancers' in major bubbles throughout history. Similar to today's version of the bank that financed massive speculation in mortgage backed securities through its SIVs ('structured investment vehicles') under the leadership of former CEO Chuck Prince (who once famously stated: 'When the music stops, in terms of liquidity, things will be complicated, but as long as the music is playing, you’ve got to get up and dance. We’re still dancing.') , its predecessor organization in the 1920's financed a great deal of stock market speculation – with similarly ill-chosen timing – under Sunshine Charley Mitchell.

Tuesday October 22 brought a recovery in stock prices, with the Dow rising 5,6 points, or roughly 1,75%. Mitchell and Fisher had managed to restore a small modicum of confidence for one day.
Babson however seemed not to share their optimism. He let it be known that 'investors should sell stocks and buy gold' – prescient advice as it turned out.

It is strange in retrospect that Wednesday October 23 never got designated 'black Wednesday'. This was certainly the day when the first truly chaotic and indiscriminate wave of selling hit the market.
Apparently the public had begun to put more stock in Babson's predictions than those of his expert contemporaries wearing rose-colored glasses.

The market opened quietly that day, but shortly before noon, selling started in car supplier stocks, and from there began to spread through the entire tape.
The plunge became especially pronounced in the last hour of trading, with 2,6 million shares traded , at the time an unheard of amount for a single hour.
The DJIA ended the day a full 20,66 points lower, at 305,85 points, only two points above the day's low. Slightly less than the entire gain of the year 1929 had been erased (the DJIA began 1929 with an opening price of 300 and a closing price of 307 points on January 2).

Once again the ticker fell behind, with cross-country communications additionally hampered by a storm in the Mid-West. A large number of margin calls went out.

Organized support made its entrance the next trading day. Thursday October 24 is nowadays widely regarded as the real beginning of the crash, and it has in fact been designated a 'black' day. Similar to today's magical thinking about government agencies supporting the market at will, there was a strong faith at the time that a consortium of New York bankers could achieve the same.

This faith was nurtured by the famous 'market rescue' ascribed to J.P. Morgan in the panic of 1907. A little bit of skepticism about these claims would probably have been in order.

For one thing, Morgan's intervention could not stem the stock market crash, which happened in spite of his efforts to prop up banks suffering runs by depositors. The proximate cause of the 1907 crash was a mistimed attempt to corner short speculators in a copper stock, United Copper Company. The trust financing the corner – the Knickerbocker Trust Company – promptly went bankrupt alongside Augustus and Otto Heinze and Charles Morse, who had attempted the corner.
The action was mistimed as it happened while an economic contraction was underway, and the people attempting the corner in addition misread the market.
They forced United's stock up from about 30 to about 50 points, but short sellers were able to borrow sufficient stock to counter the corner, and the stock promptly collapsed all the way to $10.

A typical chain reaction set in, with the collapse of the Knickerbocker Trust causing bankers to restrain their lending, and depositors starting to fear for the health of the banking system. There were many moments in this crisis when things were deemed to be 'touch and go' – inter alia NY City itself was close to bankruptcy at one point, and got a loan commitment from Morgan to avert this calamity.
The point though is that while Morgan was definitely instrumental in knocking heads together and ultimately finding a private market solution to the banking crisis, he could not avert the stock market crash.

In 1929, the 'organized support' of the NY banks was thought to be able to do just that – and it actually worked, for exactly two and a half trading days – which is oddly reminiscent of the two trading days for which the SEC's short selling restrictions seemed to 'work' in mid September of 2008, when the DJIA was driven up by nearly 1,000 points just prior to the October crash.

'Black Thursday' initially continued where Wednesday had left off – prices just fell into a bid-less void. Trading volume exploded to 12,9 million shares, more than double the previous record.
After an uneventful open during which prices actually rose a tad, volume suddenly began to swell, and with it, prices began to sag. The rest of the morning hours was characterized by a blossoming panic.

Once again the ticker tape was far behind the action, but word of an enormous collapse in prices got out anyway. This was accomplished via the bond ticker, which contained sporadic updates on stock prices that were more up-to-date than the ticker tape's. Margined speculators contributed heavily to the selling frenzy, often involuntarily.
Shortly before noon the DJIA had plummeted to an intra-day low of 272 points, down a huge 33,5 points from Wednesday's close.

That was when the 'organized support' went to work. A meeting was convened at the Morgan offices , with the presidents and chairmen of the biggest NY banks present (Sunshine Charley of National City, Albert Wiggin of Chase, William Potter of the Guaranty Trust Co. , Seward Prosser of Bankers Trust, and Morgan senior partner Thomas Lamont).
After the meeting, Lamont met with reporters, stating that 'there has been a little bit of distress selling on the stock exchange' but that this was only 'due to technical conditions' , and of course, the 'fundamentals remained sound' and the situation was clearly prone to 'betterment'.
The agency about to procure the betterment was the consortium of NY banks.

Prices immediately began to firm when word of Lamont's interview reached the exchange. Shortly after noon, Richard Whitney, vice president of the NYSE and floor trade for Morgan, went to the post for US Steel and left a limit order for 200,000 shares.
He then proceeded to leave similar orders for other key stocks at their respective posts. It was clear that the banks had moved in to support the market, and prices shot upward for most of the remainder of the afternoon. The fear of losing everything had been replaced by the fear of missing the rally. A small selling wave appeared again shortly before the close, but all in all the operation was deemed a great success. The DJIA closed with a relatively tame loss of 6,38 points, just under 300 at 299,47.

The ticker tape was over 3 hours behind that day, and many margined speculators had been sold out at the lows, so the recovery meant nothing to them. In the evening, the press was informed by the cast of usual suspects that the situation was well in hand, the fundamentals sound, and the 'technical break' over.

A contemporary account of these events can be found in this article by Time Magazine, 'Bankers vs. Panic'.

On Friday October 25, prices actually rose a tad, with the DJIA closing up 1,75 points. They softened again slightly in Saturday's shortened session with the DJIA closing at 298,97.
In terms of price movement, these two days were quite uneventful. In terms of trading volume they were anything but. Over 6 million shares traded on Friday, and over 2 million in Saturday's short session.

The weekend following the bankers' market intervention is an interesting curiosity for students of market psychology. Apparently, the previously predominating feelings of fear had almost entirely evaporated. It was as if someone had thrown the 'maximum optimism' switch.

A veritable who's who of the banking and industrial elite sounded off on the 'sound fundamentals' and the fact that 'stocks were now cheap'. Even president Hoover chimed in, insisting that 'the fundamental business of the country' was on a 'sound and prosperous basis'.
The papers were full of stories about 'buying orders piling up at the brokers for Monday's open' and exuded strong conviction that speculation could be resumed forthwith.

A few articles spoke of divine retribution that had been visited upon speculators, a warning shot that had done its sad, but necessary work.
The CEO of Associated Gas and Electric, Howard Hopson, likewise sung from this hymn sheet, declaring that 'it is without a doubt beneficial to the business interests of the country to have the gambling type of speculator eliminated'.
Several brokers joined in a concerted advertising campaign in Monday's papers, urging people to buy. This, so they said, could now be done 'with the utmost confidence'.

The banking consortium seemed to have succeeded – faith in the stock market was restored.

Late October, the crash continues anyway

As it turned out, the weekend before October 28 was one of the biggest exhibitions of wishful thinking in market history.

On Monday October 28, stocks went into free-fall – losing more on that single day than in the entire week before. Volume was once again very heavy at 9,25 million shares, with 3 million traded in the last hour alone.
Once again the ticker tape was way behind the action, but it was clear to everyone that things had to be bad. Shortly after 1 p.m. , Sunshine Charley was observed entering the Morgan office, which the news ticker duly reported.

A brief recovery in prices ensued, but Richard Whitney didn't appear on the floor this time. The market finally closed about 4 points off its lows, but the DJIA had lost over 38 points at the end of the day, a decline of 12,8%.
Similar to what we have seen in modern day crashes, the decline of the big averages didn't tell the whole tale. The more speculative and illiquid issues were hit far harder. It was an unprecedented debacle.

The bankers met again for a pow-wow that evening. Afterwards, Lamont once again met with journalists, only this time, he had no firm assurances for them. The most he would commit to was that the 'situation retained hopeful features', but he wouldn't be drawn on what those were.
He did however state that the banks did not see it as their duty to support stock prices at a certain level or protect people from losing money.
Foreshadowing a phrase we often hear nowadays when the market plunges, he said they were merely concerned with maintaining an 'orderly market'.

This is of course a bit like when CNBC's Bob Pisani nowadays announces that 'yes, the Dow has plummeted by X hundred points, but the interesting thing is that the decline was very orderly'.
The translation for investors and speculators is: 'you're losing your shirt, but let's be glad it's happening in an orderly manner'. One supposes it would be worse if it happened in the form of a disorderly panic, although the profit and loss statement presumably doesn't care about the distinction.

Thus the 'potent directors' myth was shattered by Mr. Lamont on the evening of October 28 1929, only a few hours after it had still informed the hopes of thousands of traders and investors.
The market reacted with yet another plunge on Tuesday , October 29, and there could be no doubt this time it was as 'disorderly' as they come.

Volume swelled again, although some stocks went bid-less for hours. A number of stocks were actually down by 90% during the day's trading, a fact that could only later be ascertained by dint of some people putting in 'spoof orders' well below the market that ended up getting filled.
At the end of the day, volume was recorded at over 16,4 million shares, a new record high, and the DJIA had closed down 30,57 points at 230,07 – a loss of 11,73% on the day.
This close was actually well off the day's low, which was at about 212 points. The market had been helped by short covering late in the day.
Prices were now back at the level of August 1928, but the crash was still not over.

There was a large recovery over the next two trading days, with the DJIA snapping back to 273 points by the close of October 31, but between November 4 and November 13 a string of harrowing losses drove the average back down all the way to 198,69 points.

Thus the crash had erased roughly 180 Dow points from the high, and bankrupted the bulk of margined speculators. Between October 24 and October 30, broker loans fell by $1 billion.

Incidentally, the bankers who had provided the 'organized support' were by way of rumors suddenly suspected of organizing bear raids, and Thomas Lamont was forced to defend them against this allegation in statements to the press.
The presumed 'saviors' had turned into widely despised pariahs within a week's time.

Many of the people involved in the rescue effort were in later years hauled before congressional investigation panels and blamed for the crash and its aftermath. Several were convicted for fraud and/or tax evasion (inter alia Sunshine Charley and former NYSE vice president Whitney).

The potent directors fallacy in modern times

One thing I often hear is that 'the Fed will do this or that to support the market'. In fact, the Fed has already done quite a bit. Contrary to what commercial or investment banks can do, there is in theory no limit to the Fed's operations – it can print up money at will, although this will of course always be done in the context of the buying of securities, be they treasury bonds or, as has recently been the case, mortgage-backed bonds.

Similarly, the treasury department is thought of as possessing near unlimited power to run up debts in support of 'stimulus spending' and endless bail-outs.
And yet, in spite of this near limitless fount of 'organized support' , the stock market has crashed just as badly as in 1929.

In fact, lately , the stock market has done even worse. After the crash of '29 ended on November 13, the market managed a steady recovery into late April of 1930.
Recently, the market has by contrast experienced the 'worst January in all of history' as CNBC informed us last Friday.
There is of course still a very good chance that a recovery will arrive with a delay, and the market has not yet breached its crash lows of November 2008.

While the Fed or the treasury have never said that they are aiming to support the stock market directly, there can be little doubt that this is one of the hoped for outcomes of their interventions. There is no more obvious barometer of the financial and business mood than the stock market. The hope is that by directing support at the center of the financial troubles , namely the credit markets, the stock market can also be induced to shake off its funk.

So how come the 'potent directors' are once again failing? The reason becomes clear when one thinks things properly through.
The economy and its underlying production structure are what they are. There is nothing the government can possibly add to to the economy in terms or real resources.
By intervening on a grand scale in what appears to be a distinctly ad hoc manner, it merely introduces what is known as 'regime uncertainty'.

The main question investors are faced with these days is not 'is the economy sound' (it isn't) or 'will earnings improve' (some day they will). The main question is 'what will these bozos do next'.
And yet, there is this almost touching, widespread faith that government holds the solution to our problems.

People have to believe in something – the idea that the 'wealth increase' of the bubble years was entirely illusory is still not fully embraced. It is simply unacceptable – everybody, even many former bears, hopes that the downturn, while likely bad, will prove to be just another brief slump after which a return to 'business as usual' will surely follow.
This is to say, everybody secretly prays for the bubble to return.

There are now debates between economists in the pages of the Financial Times over whether the downturn deserves to be called a 'depression' or not.
Note that the person refusing to countenance the thought is Stephen Roach, who for many years has warned of the bubble's excesses. Apparently not even he can imagine that the downturn will be a mirror image of the boom.

News flash: industrial production and capacity utilization are in free-fall all over the world; trade is suffering its biggest contraction in decades; unemployment is increasing by leaps and bounds (according to shadowstats.com , the US unemployment rate would already be at roughly 17% if it were measured the same way as in the 1930's) ; even the former polyannas of the 'Goldilocks club' are forced to admit that the downturn already looks like the worst of the entire post WW2 era.

The annual economic summit in Davos was overshadowed by the gloomy reality, but at the same time brimming with incantations and assurances of government intervention being capable of saving the day (eventually).

The fact that financial markets are apparently in violent disagreement with this view is generally put down to their inbuilt tendency to act in an irrational manner.
Sure enough, financial markets are not entirely rational. Their movement is best explained by herding and the constant feedback loop between observers and participants. This is however not to say that there is no connection between the deteriorating fundamental underpinnings and the action of the markets. The common denominator is economic man, and his liquidity preferences.
As to the 'potent directors' – today's version of them is more 'potent' than anything we have had before – and yet, reality is limiting the efficacy of their actions.

The government's actions are predicated on the notion that malinvestment can be given a shot in the arm once again (although of course no government bureaucrat would ever put it that way).
This has after all worked before. There is a difference to 'before' though.
For one thing, securities prices can not rise without limit, and neither can the prices of other assets. The only way to induce a near limitless rise in asset prices is to utterly destroy the currency in which they are denominated, but then they would still decline in real, purchasing power terms (as measured by their price ratio to gold).

More importantly though, there was never a chance to properly correct the earlier excesses when the great boom was interrupted by financial and economic crises previously. Every time the central banks and governments of the world managed to restart bubble-type activities (activities that would not be profitable absent a credit boom) before a correction could proceed to properly repair the world's increasingly misaligned production structure.

In this manner, error was heaped upon error – an assessment that the nowadays insolvent banking giants would probably have to concur with, given that they were a focal point of this accumulation of economic errors.
This can only be done up to a point – the point at which real resources are not able to support the consumption and production patterns of the bubble anymore.
We seem to have passed this 'point of no return' in the sense that not even the most massive monetary pumping exercise in human history seems able to rekindle bubble activities.

This in turn makes the faith in the potent directors a dubious proposition, regardless of their indubitably great powers. Imagine for a moment that the central banks and treasuries of the industrialized nations were to decide to go well beyond their current 'all in' posture, committing to prop up asset prices at all costs, as demanded by the Keynesians at Pimco.

In short, imagine the effort to keep markets from reaching clearing prices would be expanded to whatever extent deemed necessary.
Such an effort would likely be shipwrecked by the very markets it was designed to manipulate. The idea that governments are free to completely ignore market discipline is mistaken.
Either the currency or the bond markets or both would veto the attempt – these markets can only be strung along to the extent that they remain confident that governments will be able to acquire the resources necessary to pay back their debts via future taxation. Once this confidence wanes, the game is over.

Similarly, the central banks can not inflate willy-nilly.
At present, a strong private sector credit contraction is a countervailing force to the inflationary policies, and traditional channels of monetary expansion - specifically the expansion of credit money – are clogged by dint of an insolvent banking system.
However, central banks can always go the route of crediting the government for debt it issues to them, and they can expand such activities to the point where they overwhelm the private sector credit contraction.

An example for this is the situation in Zimbabwe. Naturally, the country was in a position that was prone to such an outcome to begin with – many years of crass economic mismanagement culminated in the government's de facto insolvency, and massive inflation was the regime's 'last resort' in order to be able to continue to pay those that kept it in power. It would be an error to necessarily draw the conclusion that this is the path we are on. Zimabwe merely serves as a very good example as to the limitations the 'potent directors' eventually must face, even if there is no legal limit to their ability to issue currency or debt.

In conclusion, we should be just as skeptical about the current government and central bank directed efforts at influencing market prices as investors in the late 20's and 30's should have been regarding the efforts of the potent directors of their time – first in the form of the banking consortium that vainly attempted to stop the crash, and later in the form of the government and the central bank, neither of which could stop the depression from playing out. Instead, their ministrations ended up making it worse.
Not coincidentally, the liquidation in the stock market took a long time to play out, and prices eventually reached levels no-one would have considered remotely possible when the contraction began.

This is why even now, one must resist the idea that an allegedly 'cheap market' is once again fit for long term investment. At the moment, it is a market for nimble traders at best, for as long as it takes for the contraction to play out.
Notwithstanding all the hopeful incantations at Davos , we can not rely on the bureaucrats to pull our chestnuts out of the fire.

note: much of the historical information was sourced from John Kenneth Galbraith's book 'The Great Crash of 1929'. While i'm no fan of him as an economist, this monograph is an excellent synopsis ot the events surrounding the crash.

The Stock Market - relative strength comparisons

noreply@blogger.com (pater tenebrarum) — Mon, 26 Jan 2009 18:23:00 +0000

1.Fundamental outlook

'Worse than expected'

There can be little doubt that current economic fundamentals are extraordinarily bad – the new stock phrase that accompanies almost every economic data release lately is 'worse than expected' – and this happens with expectations already lowered considerably. A good way of following the evolution of expectations are WS estimates for S&P 500 earnings in 2009. These have gone from $98,-/ share about a year ago to $42/share now. There have been numerous revisions along the way, and economists are similarly revising their guesses as to economic data about to be released.

It is generally agreed however, that knowledge of current economic fundamentals is not necessarily useful information with regards to what the stock market is about to do. The theory goes, not unreasonably, that the market tends to discount fundamentals ahead of their manifestation. However, as i have previously pointed out, this has generally not been true over the past decade or so. The stock market has most of the time acted as a coincident, and at times even lagging indicator, at least relative to official economic data.

Nevertheless, this does not change the fact that current fundamentals are a poor guide to market action over, say, the next four weeks for instance. There could be a rally in spite of a continuing deterioration in fundamentals, pinned on nothing but hope (the 'it's so bad it can only get better' thesis of investing), or pinned on a more reasoned approach that is based on the general idea that stocks are not merely a claim on earnings streams in the relatively near future – rather they are a claim on earnings streams into the far future.

Still, it would be good to have a crystal ball that informs us of future fundamentals. Can we make an educated guess? A large percentage of mainstream economists routinely disappoints in the economic forecasting department. One can certainly not rely on their timing, and neither can one rely on their general forecasting abilities. How many economists did in fact forecast the bust? Given that they have obviously a tendency to have too rosy an outlook even in the face of one of the worst contractions of the post WW2 era (thus the never-ending 'worse then expected' moments), why should one believe their estimates of when a bottom is likely?

A review of the known facts is in order.

1.we are in a secular bear market period, which will be marked by a secular contraction in p/e ratios, from the over-valuation seen in 2000 to an as-of-yet undetermined level of undervaluation.

2.Such a bear market is accompanied by recurring economic busts of increasing severity and duration – busts that are a mirror image of the preceding boom.

3.The current bust has a unique feature - the banking system appears on the brink of insolvency after having inflated credit willy-nilly for several decades (this is no exaggeration as the US total credit market debt / GDP ratio shows).

4.The authorities – fiscal and monetary, know only one recipe to counter the bust – inflate, inflate and inflate some more (in a combination of using the printing press and blatant Keynesian deficit spending; both methods have been thoroughly discredited throughout history in practice as well as theory, but are resorted to as a matter of course anyway).

If we only consider the above, it is clear that the current bust is of a different order of magnitude than its predecessors. While it was also precipitated by relatively tight (relative to the period preceding it) monetary policy for a short while (2004-2006) , its major feature is the sudden incapacitation of the banking system – the very system at the heart of the practical implementation of the inflationary policy of the modern day industrialized welfare/warfare democracies.

It is important to note that the final inflationary boom – the real estate mania, respectively mortgage credit bubble, already saw the stock market decline sharply in real terms, even during the cyclical, nominal bull market phase.
In other words, the only thing that drove the rally from the 2002/3 lows in stocks was the inflation of money and credit. This becomes evident indirectly by the expansion of margin credit and the enormous leverage taken on by hedge funds and investment banks during the period.

It was a levitation on hot air - based on the false confidence that everyone in the chain of credit that was extended during those years would be able to pay.
The plunging Dow/gold ratio indicated though that it was an entirely illusory boom.
Given how the authorities have reacted thus far to the bust – the central question then becomes 'will they be able to create another inflationary boom?' In other words, can reality be masked again by a new illusion of wealth based on the inflation of money and credit?

This seems a tall order – since there is a limiting factor in the real world that doesn't lend itself to eternal exploitation – the pool of real funding. It matters not how many pieces of paper or electronic chits the Fed prints up in its balance sheet expansion – the amount of real resources available to the economy can not be changed by that.

The reality of the banking sector's balance sheet implosion is currently partly camouflaged via the Fed's interventions, but it can likewise not be winked out of existence.
What the banks now lack is capital – as their existing capital has been eaten away by too many securities turning worthless, and too many debtors defaulting. The problem is that everybody else lacks capital too, or owns capital for which there is currently no use and that can not be profitably employed in its current incarnation (a number of car factories come to mind, for example).

We can conclude that the bust will be intense, and investment strategies will have to be adapted accordingly.

The time of 'buy and hold' has been over for ten years already, even though a surprising number of analysts still seems to cling to this mantra of the bull market. Perhaps they should have specified 'buy and hold t-bills', since those have outperformed the stock market by nearly a cumulative 40% over the past decade?
Likewise, it appears the 'money multiplier' has degraded into a 'money divider' as Bob Hoye has recently put it.

2. Technical conditions

In terms of the stock market's technical condition, it is surprisingly poor. Why 'surprisingly'? There are quite a few historical examples of a market crash in the fall, both in the 20th and 19th century. One common feature of all those crashes has been a subsequent rebound that went hand in hand with a lessening of credit concerns and as a rule managed to retrace at least 50% of the preceding crash wave. A notable exception to the rule was the 1987 crash that happened in the broader context of a long secular bull market – in this case, the rebound erased over 100% of the crash wave before running into temporary trouble.
The point is, it is unusual to see the market as weak as it has been so far in January right after an autumn crash.

The S&P 500 Index with Elliott wave labeling. Wave 4 is likely still in progress. click on chart for larger image

It is possible, even likely, that the expected rebound will still happen with a delay. However, given the unusual action up to this point, one must be prepared for the alternative as well – a further wave of selling. As previously discussed, the market lends itself to a relatively obvious Elliott wave count since the October 2007 high. The corrective action since the 'wave 3' low has been a bit more difficult to interpret, which is a common feature of corrective waves, as there are a great many variations possible.
From this standpoint, the main question is 'are we still in corrective wave 4' or 'has wave 5 down already begun'.

One of the arguments in favor of a rebound is the fact that a number of market participants are reportedly simply waiting for the current horrible earnings season to be over before committing new capital. The earnings season is regarded as being chock-full of the same event risk that is currently dogging economic data releases – the 'worse then expected' syndrome.

Ironically, an argument can be made that the market is actually not 'oversold' , as Carl Swenlin shows here in this 'chart spotlite' at decisionpoint.

From experience though it can be stated that the shorter term the time frame considered, the more difficult it is to forecast the likely outcome. If acting in favor of one outcome, one should always prepare a plan of action for the opposite outcome.

Assuming that the rebound will resume, the question of which sectors are most interesting comes to the fore. Below are a number of 'relative strength' charts. They show how different market sectors have performed relative to the S&P 500 over the past year – whereby their performance since the November low is what interests us here.

Airlines have outperformed the rest of the market since the peak in oil prices. Note however that this streak seems potentially endangered now, which may be a hint that energy prices are about to rebound. Option traders are optimistic on airlines. put/call open interest across the sector is the lowest in the past year, and short interest in the group's most prominent component stocks has declined sharply. click on chart for larger image

Banks have once again strongly underperformed the market of late. As can be seen here, the BKX-SPX ratio chart broke the neckline of a head-and-shoulders formation, but may already have met the target range, and is now deeply oversold. Near term, we would avoid this group from both the short and long side. There's no need to try to bottom fish given the industry's sorry state and the risk of a snap-back rally is too great to make it an enticing target for shorting. This sector is best left to those who want to play hero. Interestingly, the sector-wide p/c open interest ratio of 0,87 is actually very low compared to the readings over the past year.
Note: as the market cap weighting of financial stocks declines, their influence on the market-at-large declines commensurately. click on chart for larger image

The biotechnology index has outperformed the market since last spring. The sector-wide put/call open interest at 0,62 is fairly high compared to readings over the past year, which is to say, option traders are rather pessimistic on this group now. Good relative performance coupled with pessimism is a good omen for this sector. click on chart for larger image

The Broker Dealer Index has made no headway relative to the market since the November low, and remains in its longer term down-sloping channel. Short interest remains high, but option traders are curiously optimistic on the group. We see no reason to engage with any financial stocks, given that their outlook remains bleak. Financials should be watched for signs of getting overbought, at which point they will likely continue to provide shorting opportunities for nimble traders. click on chart for larger image

There's nothing remarkable about the performance of the Chemicals Index either, which is essentially also going nowhere relative to the S&P, following a streak of under-performance since the fall. As a cyclical sector it suffers from the sharp deterioration in the economy. click on chart for larger image

Due to containing a large weighting of Wal-Mart (WMT), the MS consumer index CMR has outperformed the broader market. The discretionary consumer ETF XLY may be the better gauge in this case – it has flat-lined relative to the broader market, which is to say, it has performed just as badly. In short, there are neither fundamental nor technical reasons at this time favoring this sector. click on charts for larger images

Disk Drive stocks have begun to outperform since the November low. It remains to be seen if this can be kept up due to the fundamental challenges faced by this industry. Still, storage is perhaps one of the better sub-sectors in the tech hardware world. click on chart for larger image

There is always a lot of worry about the pipelines of the large pharmaceutical firms, and the sector has for a long time been a downside leader (it was one of the first groups to break below its 2002 lows). However, strong balance sheets, high dividend yields and an intriguing streak of outperformance in recent months make this sector interesting. click on chart for larger image

Computer Hardware shows strong relative performance since the November low, mostly due to component stocks like IBM and HPQ. It remains to be seen whether this can be kept up – option traders are optimistic, and there are a number of fundamental reasons to remain wary.
click on chart for larger image

Internet stocks are helped by GOOG's less than horrible recent earnings report. There is however nothing especially exciting here. click on chart for larger image

The upcoming period of seasonal strength in energy could help both the XOI and OSX. XOI currently looks better on a relative strength basis, but the OSX is traditionally lagging, and usually has a higher beta, so it could play catch-up. click on charts for larger images

RTH's relative strength is helped by Wal-Mart (WMT). For obvious reasons, retail stocks should probably be avoided. The best thing that can be said for them is that most are technically oversold by now. click on chart for larger image

Networking stocks have been going nowhere in particular relative strength-wise in a wide channel. click on chart for larger image

The Semiconductor sector has recently strengthened as well, but the group remains suspect for fundamental reasons. click on chart for larger image

The relative strength chart of the telecommunication group is intriguing, as it is attempting a break-out. click on chart for larger image

The point of this exercise is basically, 'if you have to be long something, choose whatever shows good relative strength' . Two of the biggest reasons why I personally have become a bit more constructive vis-a-vis the stock market in the near term can be found below (please note, i remain medium to long term bearish):

The US dollar index appears to have built a bearish flag – a decline in the dollar would likely go hand in hand with rising stock prices. click on chart for larger image

The safe haven buying that supported the huge rally in T-bonds has subsided. The initial correction target has been met, so a rebound is increasingly likely. However, the bearish influence the bond market had on stocks has clearly lessened (currently, lower interest rates on long term government bonds are a bearish, not a bullish sign for stocks). click on chart for larger image

3. Gold and gold stocks

I'm looking at gold and gold stocks in a separate section because the gold stocks are currently the one market sector with the best fundamental and technical outlook.

Here is why:

Gold weekly, 3 years. this chart looks constructive click on chart for larger image

On the daily chart we can see that a big test lies just ahead for gold - the resistance in the 920-930 area that has stopped the previous rally attempt. It seems likely that this won't be overcome on the first attempt. Breaching this resistance would be a a very positive sign. click on chart for larger image

Gold keeps streaking higher against the S&P index. At the moment it is attempting a new break-out in relative strength terms click on chart for larger image

Gold has risen enormously relative to crude oil. Energy is a major input cost for gold miners, so this is a boon for their profit margins. Interestingly, Wall Street analysts are generally very lukewarm toward gold stocks. click on chart for larger image

Since the low was put in, the HUI has risen sharply vs. the SPX, but the relative strength chart is now running into short term resistance.

To reiterate something I have mentioned before: the gold sector will probably be the only major market sector to deliver earnings growth in coming quarters. In spite of this, it is strangely unloved by many in the Wall Street analyst community.
Let me name a few examples.

Newmont Mining (NEM) for instance currently sports 4 'strong buy', one 'buy' and 8 'hold' ratings ('hold' is the Wall Street euphemism for 'you should have sold it yesterday'). Put/Call open interest on the stock has soared in the past few months, from roughly 0,60 to about 1 now.

Barrick Gold (ABX) has 6 'strong buy', 1 'buy' and 7 'hold' ratings; put/call OI on the stock has also soared lately.

Goldfields (GFI) has 1 'strong buy', 2 'hold', and 1 'sell' rating. Note in this context that the price of gold in South African Rand is at a new all time high (!) , while GFI trades about 65% below its former all time high. p/c OI on the stock has doubled of late.

Harmony Gold (HMY) has 1 'strong buy', 1 'hold' and 1 'strong sell' rating. I'm not sure who dispensed the 'strong sell', but the company's balance sheet is stronger than it has been in years, it has 5 growth projects in the pipeline, and the fattest margins in at least 5-6 years.

You get the drift – Wall Street isn't exactly brimming with love for gold stocks. This is of course excellent news for anyone holding them, as it increases the chance for future upgrades.

Gold in South African Rand. This is a nice, steady bull market progression. The profit margins of South Africa's gold mines are soaring along with it.

another housekeeping note

noreply@blogger.com (pater tenebrarum) — Thu, 08 Jan 2009 13:47:00 +0000

Unfortunately i have not yet found the time to reply to the many interesting and often thought-provoking comments and queries that have been made in recent weeks.

I will try to reply to as many as possible over the coming weekend.
So if you have been waiting for a reply to a comment, best check back on Monday , January 12, by which time my replies should be posted.

I will try to do my best to post replies in a more timely manner in the future, but can not guarantee that that will always happen - thank you for your patience and understanding.

Let me also take the opportunity to somewhat belatedly wish everyone a happy and prosperous new year.

pater tenebrarum

Krugman's interventionist crusade

noreply@blogger.com (pater tenebrarum) — Tue, 06 Jan 2009 14:06:00 +0000

The high priest of interventionist economics

From his perch at the New York Times, Professor Krugman has been dispensing economic and political advice for many years. Unfortunately, he is to economics somewhat similar as Ben ('you have to buy financials here') Stein is to investments, in short, he is potentially capable of doing a lot damage.

For this reason alone, his views must be challenged from time to time, even though we poor bloggers do certainly not have his reach. My fellow blogger and friend Mish has recently done so , in a blog entitled 'Krugman still wrong after all these years'.

He certainly is, and i want to take the opportunity to add a few complementary thoughts to Mish's ruminations on the topic.

First of all, i would recommend this paper(pdf) by Daniel Klein and Harika Bartlett, in which Krugman's editorials have been analyzed statistically and then interpreted by the authors.

The verdict is clear: Krugman is propounding a social-democratic ethos , even though he curiously never admits it outright.
On the contrary, he presents himself as somehow being 'above ideology', while at the same time managing to be one of the most vocal and well known advocates for statism and interventionist policies in the economics profession today.

As the paper notes, if one thoroughly looks at e.g. his concern for the poor, it turns out that this concern is trumped by his support for statist intervention – this is to say, when the choice is between a policy of liberalization that clearly helps the poor and a continuation of a regime of regulation harmful to their interests, he will always favor regulation (by simply remaining silent on the topic).

His record of favoring markets apparently consists of a single assertion in one of his editorials which he purports 'not to be against the market' – a statement that is then thoroughly contradicted in almost every paragraph of the hundreds of articles he has written.
He has come out in favor of liberalization in exactly two cases in his writings for the NYT from 1997 to 2008, which comprised 645 editorials as of January 2008.

Krugman's political ethos is also marked by the 'social compact' chimera – he strongly supports democracy, because the act of voting in his mind legitimizes state coercion.
After all, you have a choice, so this theory goes. If you're not happy with the status quo, vote against it.
We all know however that this is not how it works in reality. You can not opt out, or vote against the status quo, because that choice is simply not presented in elections.
In the US specifically, the two party system is akin to a one party system with only slight shades of difference in emphasis regarding the types of statist policies that are supported.
In this context read Albert Jay Nock's very interesting and entertaining essay 'What the American votes for', in which he explains why he decided to abstain from voting, respectively only voted for people that were already dead.

Criticism without basis

Occasionally, Krugman will criticize the Austrians (whom he doesn't name – he calls them the 'liquidationists' instead – presumably short hand for everyone who thinks the state should not intervene to stem the bust), who in turn frequently criticize right back.

Curiously, Krugman does his utmost to ignore the Austrian school's arguments – it is as if he is aware he's being criticized, and given that the views of the Austrian school are lately gaining a certain degree of credence with the public, finds it necessary to publish an occasional criticism, but at the same time is studiously avoiding to actually read what they have written.

In his recent article on what he calls the 'Hangover Theory' , which can by implication only refer to Austrian Business Cycle Theory (ABCT), he once again roundly ignores arguments that have been sent his way quite some time ago already.

This can only mean one of three things:
A) he doesn't grasp the arguments (unlikely), B) he didn't read any of them, nor any of the classical works (possible i guess) , or C) he has read them, but now makes as if they didn't exist, thereby misrepresenting them by omission.

As Robert Murphy shows here by means of a little economic anecdote, Krugman simply ignores the role of capital (a failing of Keynesianism in general), and its intertemporal structure.
Now, he has either read Murphy's piece or he hasn't, but he sure does ignore it completely. Most importantly he ignores the point that during the boom, resources will be misallocated, which in turn leads to consumption of capital.

I urge everyone to read Murphy's article, as it lucidly explains why the view of the economy as an agglomeration of 'aggregates' is wrong – and how in an artificial boom, misallocation of capital along the production structure leads to capital being consumed and falling into disrepair.
As Murphy correctly remarks, it is vital to understand this part of the ABCT if one wants to sensibly contribute to the debate. It is the process of capital consumption – respectively consumption of the pool of real funding, or put in other words, previously accumulated wealth - that creates the illusion of the boom.

The master builder

Ludwig von Mises had numerous little common sense quotes and anecdotes in which he tried to paint an easy to understand picture illustrating such concepts.
With regards to capital consumption, he referred to consumption without preceding production (which is a side effect of the fiat money system's 'money out of thin air' creation) as akin to 'burning the furniture to heat one's home.'

One can do that for a while, and the house will be nice and warm for some time, depending on the amount of furniture available to burn. One day though, one will perforce run out of heating material, and voila – the home will grow cold (as a metaphor for the inevitable bust resulting from capital consumption).

Another von Mises anecdote that illustrates scarcity and the importance of correct – i.e., market-based - information in guiding entrepreneurial decision making, is the one about the master builder.

Imagine the Pharao charges you with building him a palace. At the outset, you are informed how many pieces of wood, hows many bricks, nails, glass panes, shingles and other building materials will be at your disposal.
In short, you seemingly have perfect information about the resources available to you.

However, someone made a mistake – there are in fact 20% fewer bricks available than you were led to believe. Some of the crew discover the mistake, but given that building the palace means a good time for everyone – they all have jobs, they're building a nice palace, everybody, including the builder seems happy – they decide to keep you in the dark about it.

You will of course succeed in erecting the foundation, and perhaps in building up to say, the first floor.
However, the building you have planned on the basis of this incorrect information will forever remain unfinished – at some point, the bricks will run out prematurely.

It follows that the earlier in the process you learn of the error, the better the outcome will be.
If you learn of it while still drawing up your plans, you can plan anew, and only some of everybody's time will be lost. If you learn of it after having built the foundations, there may still be time to change plans for a somewhat smaller, but still doable palace. If you learn of it one day before the bricks actually run out, it will simply be too late – a monument to malinvestment will have been erected – an unfinished palace.

The resources that have been used up in erecting this unfinished building have been used up, and while everybody had a 'good time' (the boom) while doing that, they are now faced with the fact of an unsalvageable and uneconomic project standing before them.

Relevance to the economy at large

The problem presented by an artificial credit boom to the whole economy is akin to this master builder problem. In this case, the artificially low interest rate is what creates a fata morgana – i.e. a crucial piece of misinformation – that leads businessmen astray, namely the illusion that more savings are available than there really are.

It is the conceptual difference between money and real resources that trips up Krugman. He thinks if only someone – preferably, in his view, the state – were to spend money in the teeth of the bust, everything would be alright again. This ignores what has happened in the boom – scarce resources were misallocated due to false information on the true state of savings, and thus capital ended up being malinvested and consumed.

If we look at the policies enacted since the bust began, we see that they are all geared to keeping the disinformation that the boom was based on alive.

Once again, interest rates are being suppressed to an artificially low level. The state meanwhile is set to spend more money than at any time before in such a brief time span in peace time, on the idea that more spending is going to cure what too much spending has wrought.
However, the state can not add one iota to the pool of scarce economic resources that need to be optimally allocated if the economy is to recover.
We must always come back the the fact that the state does not have any economic resources of its own – it does not produce any. Instead, it must take them from those who do produce them.

Listening to Krugman, you'd think Austrians were a bunch of sourpusses begrudging everyone the good times of the boom, and then making things worse by being especially dour party-poopers with regards to the remedies thought to be necessary 'fix' the bust.
However, it is just realism and rigorous a priori reasoning that leads to their conclusions. Once the economy's pool of real funding has been damaged on account of an artificial credit boom, the priority must be to allow the production structure to readjust to reality, and that process, while painful, is also necessary.

The efforts of a coercive redistribution agency (the government) can not change that, and the printing of more fiat money can not either.
What the introduction of these factors does is to upset the market process.
They are deliberately used to induce booms (booms are politically popular until they go bust), in the hope that someone else will have to deal with the consequences (as is indeed the case; Bernanke gets to deal with Greenspan's legacy, and Obama with Bush's), and when those consequences inevitably arrive, they are used again in a futile attempt to keep those consequences at bay.

As long as the pool of real funding hasn't been damaged too excessively during a boom, a dose of monetary pumping can be expected to revive the illusionary boom – as has indeed happened several times in the past, most recently after the technology bubble flamed out.
The problem is that this only stores up even bigger problems for the future. We can all clearly see now that Greenspan's attempt to prevent the previous correction/bust from doing its work has led to an even bigger, more intractable bust in the present, but the interventionist caste still insists that we have to do the same thing all over again, only in larger dosage!

Once a boom turns to to bust, there are a number of facts that need to be faced:

1. there were not as many savings as thought, so capital was misallocated;
2. what the economy needs is as little interference as possible, since otherwise the danger is that even more capital will be misallocated.
3. the process of realigning the capital structure to reality is not painless, since it requires far fewer workers than are are needed when everything is humming.
4. the less interference there is, the faster it will be over.
5. to interfere means de facto to burden an already weakened economy even more – therefore, the more intervention, the less desirable the likely outcome (and it's not as if we didn't have any examples for that).

The pretence of knowledge

Lastly, look at how Krugman argues in favor of state intervention and spending to 'mitigate the bust'. His argument in favor of increased fiscal spending in Europe is summed up as follows:

dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]

Read the linked article for an explanation of the formula.

This is what Hayek referred to as the 'Pretence of Knowledge'.
Modern day economists seem to think that if it can't be put into a formula, then it can't be science. Economics is however a social science, not a natural one. It is about human beings, and the interactions of millions, nay billions, of human beings can not be pressed into neat little formulas.

This is not to say that one must completely abandon a formulaic approach to certain economic concepts (a graphic representation of a supply-demand curve surely has its place for instance), only that the 'ceteris paribus' type equilibrium which these formulas assume to be in place is not present in the real world.
The science of economics must proceed from sound a priori reasoning, otherwise it can not present the proper conclusions and provide policy recommendations.

It is this latter point that should worry us all. Krugman and other supporters of interventionist dogma are self-styled advisers to the political class, which in turn likes to hear nothing better than advice that prods it to intervene.
The courtier economists are thereby apt to doing a lot of damage, as mentioned in the opening paragraph.

Naturally, few economists would be prepared to admit that they actually don't know what to do. In this, the Austrian school is quite different. It essentially says: 'The entity that knows best what is to be done is the free market. Let it work'.
In other words, they have no 'policy recommendation' except - 'do nothing'.
When Ludwig von Mises was once asked what his first action would be if he were to be appointed 'minister of economics' he answered: 'Resign'.

It's not the type of advice one can easily make a living from. The interventionist courtier economist of Krugman's type on the other hand is asked to draw up plans, has the ear of the powers-that-be, gets to feel important , and gets paid nicely for his efforts.

Furthermore, as has been shown over and over again, the fact that intervention does not work is never seen as a reason to abandon it, but rather to come up with new, additional interventions purportedly designed to fix the unintended consequences of the old ones.
In this manner, the power of the state grows and grows – which is to the advantage of both the political class as well as its 'advisors' and everyone feeding at the state's trough (including many corporations; contrary to what one would think, most corporate entities are not in favor of a free market either – rather, they seek protection from competition in the form of anti-competitive regulations, respectively seek a slice of the tax payer pie that is doled out by the political class in its favors and vote buying activities).

What is to the advantage of the political class and its advisors and hangers-on is however as a rule to the disadvantage of everyone else.
If we want a sound economic policy, we must oppose Krugman's call for more intervention.

Off Topic – Serial Music

noreply@blogger.com (pater tenebrarum) — Thu, 25 Dec 2008 18:28:00 +0000

Another Austrian invention

there is another field pioneered by Austrians, one perhaps even better known than their contribution to economics – namely serial, or dodecaphonic music, a.k.a. 12-tone music.

The most famous composers of such music were Arnold Schoenberg, the inventor of the 12-tone technique, and his contemporaries Anton von Webern and Alban Berg. In modern times Karl-Heinz Stockhausen, Luigi Nono, Milton Babbitt et al. became well known proponents of this type of music.

Lesser known, but no less interesting, is Josef Matthias Hauer, who made his own contribution to serial music theory by introducing the so-called 'tropes' – a method for constructing chords in music without a specific key that allows for the composition of less 'dissonant sounding' 12-tone music. This method was developed independently of Schoenberg's theoretical work.

Take a look at this interview with classical pianist Mitsuko Uchida on Schoenberg and his piano concerto op. 42; she is one of the foremost interpreters of this work, which is extremely difficult to play (as she explains in the interview, this partly owes to Schoenberg not playing the piano very well, so he didn't consider the technical troubles a pianist would encounter when trying to play this composition, perhaps unwittingly making it a real tour-de-force for the interpreter).

Mitsuko Uchida on Schoenberg's piano concerto, opus 42

Note her mentions of the original 'tone row' (P0), the retrogrades, inversions, etc. - an explanation of these terms follows below.

A little bit of theory

Serial music favors a seemingly very 'mathematical' approach to composition, as it has certain specific rules, that govern the order in which different pitches can be used. At the core of the theory is Schoenberg's idea that 'no note should be accorded more importance than any other'; this is achieved by the rule that once a note of a '12-tone row' has been sounded, it may not be heard again until all other 11 notes of the row have been sounded. A tonal democracy so to speak, or rather, an atonal democracy.

Serial composers do not really think in terms of 'notes' – rather, they refer to them as 'pitch classes', that are typically numbered. For instance, if one were to write down a 12-tone row consisting simply of a chromatic scale beginning with 'C' , then the note 'C' would be termed pitch class 0, C# would be pitch class 1, D would be pitch class 2, etc.
Note also, in terms of notation, accidentals (#,b) are only valid for the pitch immediately following them, not for all subsequent appearances of the pitch, and enharmonic spellings of the same (well-tempered) pitch , like e.g. C# and Db are used indiscriminately.

At the beginning of every serial composition is the initial, or prime tone row, P0. This could for instance be:

D, G, F#(Gb), D#(Eb), C, B, A, E, G#(Ab), A#(Bb), F, C#(Db)

(this is the basic tone row that was used in the composition 'Matrix' that is available for free download at the bottom of this post).
If we were to write down this tone row in numbered pitch classes, it would look thusly:

0, 5, 4, 1, 10, 9, 7, 2, 6, 8, 3, 11

The above 12-tone row in normal musical notation - below the notes the respective pitch class numbers click on image to see larger version

Next one constructs from this original tone row P0 a number of additional tone rows, that are all derived from the original with a simple mathematical method. These basic transformations of the tone row are referred to as transposition, inversion, retrograde, and retrograde inversion. One thus arrives at 48 tone rows (P0 transposed 12 times, inverted 12 times, mirrored 12 times, and inverse-mirrored 12 times).

This can be done using a matrix. First one writes down the original tone row at the top, from left to right, then one constructs the inversion I0, writing it down in the first column to the left. The inversion is constructed by finding the complements to the pitch classes of P0, which are given by the number that when added to the pitch class number will equal 12.
Thus the inversion I0 of the above tone row P0 will be:

D, A, A#(Bb), C#(Db), E, F, G, C, G#(Ab), F#(Gb), B, D#(Eb) ,

or in pitch class numbers:

0, 7, 8, 11, 2, 3, 5, 10, 6, 4, 9, 1

from the pitch class numbers in the top row (P0) and left-most column (I0), all the other transformations are easily deduced. The numbers of the first row are at the same time the index numbers of the inversion columns, while the numbers of the first column give us the index numbers of the transposed rows. Thus the second row in this example will be P7, or P0 transposed by 7 half-tones, the third row P8, the forth row P11, and so forth. The second pitch class of P7 is determined by adding the second pitch class number of I0 to the second pitch class number of P0 modulus 12, the third by adding the second number of I0 to the third number of P0 mod 12, etc.
The rows when read from right to left give us the retrogrades (mirroring the intervals), the inversions when read from bottom to top give us the retrograde inversions (mirrored intervals of the inverted tone rows).

The entire matrix then looks like this:

The 12-tone matrix in numbers click on image to see larger version

or in terms of notes:

The 12-tone matrix in notes; P 0-11 are the original tone row plus its transpositions; I0-11 the inversions of the tone row and its transpositions, R0-11 the retrogrades and RI0-11 the retrograde inversions.
This matrix is the 'raw material' from which a 12-tone composition is made. click on image to see larger version

Josef M. Hauer , whom I mentioned earlier, developed methods that retained some of the features described above, while introducing new ones, especially w.r.t. construction of chords. Below a handwritten sheet of chords constructed with Hauer's method. (note: the letter 'H' is how the note 'B' is referred to in German). The main difference: it doesn't sound quite as 'dissonant'.

A picture of chords constructed with Hauer's method; the 12-tone rows (circled in red) are the only thing that changes – all other notes remain the same as one progresses; the notes are taken from the groups of 3 notes in the immediate vicinity of each other – whereby one starts with the ones next to the first note in the tone row. The 12-tone row moves like a snake through the chords. click on image to see larger version

This is only a very basic overview over the theory – if you wish to learn more, further introductory material can be found here: 12-tone composition

A labyrinth worth exploring

If one is not familiar with 12-tone music, it may seem a bit difficult to swallow at first, so to speak.
Milton Babbitt famously declared that he didn't care if anyone liked his music.
His argument went like this: most people don't understand it, but that is not an indicator of its worth. If a layman were to walk into a congress of nuclear physicists he wouldn't understand a word either – and so presumably would the majority of people, but that does not mean nuclear physics is not a worthy endeavor.

The infamous Babbitt essay 'Who cares if you listen?' is where these thoughts were formulated. Advanced music is for advanced listeners, so Babbitt. The rest have no basis by which to judge this type of music, just as a radio repairman has no basis to criticize the work of a nuclear physicist.
To some extent i'm sympathetic to this argument – as long as some people find enjoyment from dodecaphony, there is sufficient proof of its worth.

Popularity may count in pecuniary terms, but it is hardly the main criterion by which to judge art. Naturally, Babbitt put off a lot of people with his elitist essay, but he probably reckoned, so what? Those were the people who wouldn't listen to his music anyway! Here you find btw. an interesting early 80's article by Greg Sandow on the 'fine madness' of Milton Babbitt.

This elitist argument was carried even further by a German composer: Karl-Heinz Stockhausen. When asked by a student in the 1970's if the use of electronic instruments like synthesizer modules in his compositions would not risk losing a valuable and very important component of music as artistic expression , namely human emotion, he answered that he thought people were simply afraid.
Afraid of what? Afraid of not belonging to the newly evolving species of man that could relate to this type of music. He regarded modern music as accompanying the next step in human evolution - to truly grasp it, you had to have 'evolved' , or at least be in the process of evolving, to the next stage of human consciousness.

Oh well, what can one say to that. :) A recording of Stockhausen's 1972 lecture is below:

Stockhausen on human evolution and music, 1972

My experience is as follows: most people are rather taken aback when hearing serial music for the first time – chances are, after all, that they will hear a 'difficult' piece , since by their very nature, most pieces are difficult , and often dissonant.
In spite of its 'mathematical construction' aspect 12-tone music often gives the initial impression of being chaotic and disorganized - which of course it is not, but few people will realize it at first. It certainly is what one would call 'uncompromising' – it doesn't exactly cater to popular tastes.

You might ask, how does the composer actually introduce emotion when he works with tone rows that have been calculated beforehand? This is done by making use of all other aspects of musical expression. Rhythm, the way the various tone rows are interlaced, the timing of musical events, textures and tone colors, the type of instrumentation used – all can be and are used to create an individual artistic expression within the confines of the system. Naturally, great masters like Schoenberg and others occasionally would break their own rules. Once you know the rules well, you also know how to break them effectively after all.

It is generally unlikely that the untrained listener will immediately find his way to enjoying serial music. For one thing, it lacks the patterned, repetitive elements we are used to hearing in most tonal music; in addition, it frequently sounds dissonant, although as J.M. Hauer's work proves, this does not always have to be the case. Here is a rare recording of a Hauer piano piece as an example:

Josef Matthias Hauer's Klavierstuecke, opus 25

Nevertheless, it is a labyrinth well worth exploring – as Ms. Uchida remarks in her interview, there are a number of composers such as Debussy who did not use the 12-tone technique, but still left tonality largely behind in many of their compositions. Debussy is probably a good way of approaching atonal music 'painlessly' initially, before one takes the next step of exploring Schoenberg and the modern age composers.
I for one disagree with both Babbitt and Stockhausen – neither do I think it doesn't matter whether anyone listens to the music, nor do it think you need to climb the next step on the evolutionary ladder in order to find enjoyment from this type of music as opposed to being 'afraid' of it.
To be sure, it is not for everyone. If your idea of aural fulfillment is the next Britney Spears hit single, then forget it. Even if you like classical (a.k.a. 'serious') music it does not follow automatically that you will like 12-tone music. There's a pretty wide gulf between Mozart and Schoenberg after all.

A tip for getting acquainted with Schoenberg: his 'Variations for Orchestra', opus 31.

The Electronic Primitivism Project is a loose association of musicians that plays mostly my compositions. Below you find for free download a serial music composition for synthesizer and orchestra. It uses both Schoenberg's and Hauer's methodologies , as a result it sounds alternately tonal and atonal – furthermore, there is some rule-breaking trickery involved in several passages, whereby a 12 tone row was sent through sequencer combined with a so-called voltage quantizer; the quantizer takes incoming pitches and then picks the most nearby pitches conforming to a scale (in this case, minor scale) that has the incoming pitch as its tonic keynote. Thus, every time a new pitch class is received by the quantizer it will begin transposing to a new minor scale; in this way the 12-tone row is serialized in a new manner – as a series of different tonal scales.
It's probably best to download the mp3 file and listen to it over a system resp. headphones with good stereo imaging. By the way, the gentleman who unwittingly lent his hacked-to-pieces voice to the final vocoded part is Shimon Peres.

Please note: even though this is for free download, I retain the copyright – no commercial use without my consent (as unlikely as commercial use of this stuff is) and if reproduced for private use, the EPP must be identified as the author.

Matrix (P0: D, G, F#(Gb), D#(Eb), C, B, A, E, G#(Ab), A#(Bb), F, C#(Db)) - 58,6 mb

The war on savers and how it damages the capital structure

noreply@blogger.com (pater tenebrarum) — Mon, 22 Dec 2008 05:47:00 +0000

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

Some thoughts on the recent backwardation in gold

noreply@blogger.com (pater tenebrarum) — Fri, 19 Dec 2008 17:47:00 +0000

Definitions

Let me start with a definition of the term 'backwardation' for readers that are not familiar with it.
A commodity like e.g. crude oil that trades in a futures market, has many different contracts trading concurrently, for different delivery dates in the future. Normally, the contracts for later delivery will trade at higher price than those for earlier delivery. This 'normal' state of affairs is known as 'contango'.
The reason why contracts for later delivery are normally higher priced is that they must reflect two cost factors that are a function of time.
One is storage costs; obviously, it costs more to store 1000 barrels of crude oil (the size of one NYMEX light sweet crude contract) until January of 2010 than until January of 2009.

The other is opportunity cost; by tying up funds for the purchase of crude oil for future delivery, these funds are no longer available for other purposes – the simplest of which is earning a risk free interest rate.
Putting it differently, a futures market will normally reflect the 'cost of carry' – the cost one incurs by holding the underlying commodity from the current moment in time to the day of delivery.

However, the futures curve also reflects other considerations; the major one is the market's perception of the state of estimated current supply compared to expected future supply. For instance, at present, the futures curve in crude oil shows an unusually large contango – so large that people are scratching their heads over it, as it allows one to make very large arbitrage profits by simply storing oil and selling it forward.

Apparently the oil market currently has two major concerns:
1. current supplies are more than ample – the market is in fact oversupplied in view of a sharp fall-off in demand.
2. the low prices of today make a far less benign supply situation in the future more likely, as many oil production expansion plans are being shelved due to the recent price collapse.

Occasionally though, and at times for extended periods, oil has been trading in backwardation – meaning, that the futures curve looked opposite to its normal shape – spot oil and near delivery months traded at a (often large) premium over later delivery months.

Whenever an industrial commodity is trading in backwardation, one can be sure of one thing: current supplies are very tight relative to demand. Backwardation discourages storage by making it very costly, and is the market's way of drawing as much of a commodity out of storage as is possible, as users need it in the here and now.
Thus the 'abnormal' situation of a backwardation in a futures market has an economically valuable function: it informs market participants of a supply shortage in the present, and by making storage a costly proposition and allowing for an arbitrage that makes it profitable to sell a commodity in the present and buy it in the future, it draws supplies out of hiding, which will eventually tend to alleviate the shortage.

A gold backwardation is different

Let us now proceed to looking at the recent backwardation in gold (in the meantime the market has reverted to a slight contango, but this seems poised to reverse again, as gold forward rates have resumed falling).
After reading the above paragraph on backwardation and contango, one might be tempted to conclude that a backwardation in gold is no different from one in say crude oil, or copper.
However, this is definitely not the case.

Many readers of this blog are probably familiar with Mike 'Mish' Shedlock's blog 'Global Economic Trend Analysis' and may have followed the recent back and forth between Dr. Antal Fekete and Mish on the topic of the recent brief gold futures market backwardation.

It began with Dr. Fekete's somewhat alarmist (but nevertheless quite interesting) article 'Red Alert: Gold Backwardation!!!', from whence it proceeded to one of Mish's frequent conspiracy-debunking blogs entitled 'Nonsense About Gold Backwardation, Ameros,Yuan Devaluations, etc.', which prompted Dr. Fekete to reply, a bit miffed, with 'There Is No Fever Like Gold Fever', followed by another rebuttal by Mish 'No Fever Like Gold Fever: Response'.

This latter article quoted me, following an e-mail exchange with Mish in which we discussed the situation. Since Dr. Fekete's article struck me as overly alarmist at the time, and I thought that the backwardation was probably mainly a short term anomaly, I was rather dismissive of the claims made therein.

For one thing, the gold forward curve is supposed to be quite flat at present – after all, official interest rates all over the world have been slashed to the bone, and this lowers gold's cost of carry commensurately – the opportunity cost of holding gold has declined sharply.

Secondly, we know that demand for small denomination physical gold has recently soared, which has surprised refineries that now have difficulties to deliver all the gold demanded in a reasonable time span.

Thirdly, it has been known for some time that gold lenders (mostly central banks) have become reluctant to lend out gold, due to rising concerns about counter-party risk.
This can be inferred from the gold lease rate, which has recently risen quite sharply. Since it is also a well known fact that forward selling on the part of gold miners has become very rare , a rising lease rate can only mean that the supply of gold for lending purposes has tightened (what little forward selling there is done is almost always tied to project development debt finance, but this is still easily overwhelmed by the ongoing covering of stale forward sales by large established producers like e.g. Anglogold, that has only fairly recently adopted a 'no more hedging' policy under its new CEO).

The LBMA's 3 month gold lease rate, courtesy of Lance Lewis. There has been a recent spike indicative of tightness in the gold lending market. click on chart for larger image

I did however mention that a backwardation had to be regarded as bullish, and I conceded that in the case of Zimbabwe, Dr. Fekete was perfectly right: it does not matter anymore how much money in terms of Zimbabwean government scrip one offers to a holder of gold in Zimbabwe - he simply won't sell. This, as I put it, is what happens once an inflationary conflagration of a fiat currency reaches the 'point of no return'.

Hyperinflations have several distinct stages that have been observed throughout history – in the course of the acceleration of inflation to ever higher rates of change, there always comes a certain threshold point – what I refer to as the 'point of no return'.
This is the point at which the public realizes that the inflation is a deliberate policy that is set to continue, for the simple reason that the government issuing the money in question is technically bankrupt.
What usually happens then is that the decline in the respective money's value begins an irreversible acceleration that stops only with the complete repudiation of the money concerned, even if the government stops printing more money, respectively prints far less than would be indicated by the acceleration in price increases.

We can actually observe this in Zimbabwe, where the government's bankruptcy has proceeded to the stage where it can not even afford the paper and ink anymore that it would need to print additional currency. Thus there is now hyperinflation (recently estimated at 500 billion percent annualized) concurrently with a deepening cash shortage.

In essence, the market has declared the government's scrip to have no value at all, and economic activity is increasingly reverting to barter.
Once the 'point of no return' threshold of an inflation is crossed, one can not hope to get any more gold in exchange for the government's scrip. One may be able to exchange other goods of value or foreign currency for gold, but not the fiat money in the throes of hyperinflation.
There may still be gold prices quoted in the inflating currency, but this is strictly a technicality, respectively illusion.

So why then did a slight backwardation in gold futures lead Dr. Fekete to exclaim that the irredeemable fiat dollar was about to meet with a similar fate? You may need some background on what makes gold different from industrial commodities – my brief article 'Misconceptions about Gold' posted under the nom-de-plume Trotsky at Mish's blog a while ago can be used as a primer.

The thing is, gold normally never goes into backwardation. One of the reasons why gold has been chosen as money by the free market is the fact that a large above ground supply exists – a supply so far in excess of the amount of newly mined gold added to it every year that it promises both to be stable and ample enough to successfully serve as money.

This large supply also ensures that normally, the gold futures curve will always be in contango – there can be no 'shortage' of gold similar to, say, a shortage of copper or oil.
The contango in gold futures meanwhile changes largely along with changes in the Fed's administered interest rates – expressing the either falling or rising opportunity cost of holding gold relative to the government's irredeemable scrip.

Copper and oil inventories can and are, usually measured in 'days or weeks of demand'. These are commodities that are used up in industrial applications, for which the annual primary supply/demand situation is quite important and determines the size of the inventory and consequently the shape of the futures curve.
There can be a shortage of copper, respectively a supply situation that is so extremely tight that a shortage seems imminent. When that happens, the copper curve will be in backwardation, often markedly so.

In light of the above, one must concede that Dr. Fekete has a point, even if he went overboard with his declaration of imminent monetary Armageddon.
If we look at the going-ons in the December GC contract specifically, it elicited a large demand for physical delivery, with about 12,000 contracts (equivalent to 1,2 m. oz.) standing for delivery in spite of a temporary backwardation that makes a 'sell now, take delivery later' arbitrage profitable.

The LBMA's 3 month gold forward rate (a.k.a. 'GOFO'), also courtesy of Lance – the only time this forward rate temporarily spiked into deep backwardation since 1990 was just prior to the announcement of the 'Washington Agreement' that limited central bank gold sales and gold lending activities; a huge short term surge in the gold price ensued. It is notable that GOFO usually tends to reach very low levels just prior to major bull moves in gold – this is only natural considering that a flattening of the forward curve is indicative of a falling opportunity cost of holding gold. click on chart for larger image

Concurrently we observe a fairly regular increase in the gold holdings of the gold ETF GLD; recently these holdings have reached a new record high of 670 tons. Over the past several months, the gold holdings of the ETF have either remained fairly stable or have risen regardless of the gyrations of the gold price itself.
This is a microcosm of sentiment among a certain – important - group of gold buyers.

These buyers represent exclusively monetary(or investment)demand, and they buy irrespective of short term price movements. Clearly, this group of buyers is very worried about the recent systemic crisis, and considers gold as an important form of insurance.

Exchanging promises for more promises

Anyone with assets to protect has probably given some thought to gold's ability to serve as a long term protector of wealth in light of recent large scale failures in the financial system.
If one has a large amount of money deposited with a bank, one has to confront the these days very real risk that the bank might go under; the bank's promise to produce one's money on demand looks a lot shakier than it once used to.
One possibility is to buy government bills, notes and bonds, something that countless big investors are in fact doing lately, inter alia because no other market is more capable of digesting very large sums without a hitch. The liquidity of the government debt markets is unparalleled.

However, one simply exchanges the bank's promise to pay for the government's promise to pay – and both the bank and the government only promise to pay in yet another promise to pay, namely the Federal Reserve's, in the form of the bank notes it issues.
Furthermore, here is where things become circular, lately with a twist. While the bank notes represent the central bank's liability, it normally has government debt on the asset side of its balance sheet – a promise to pay 'backed' by a promise to pay.

The 'twist' these days is that the asset side of the Fed's balance sheet increasingly consists of all sorts of garbage as a result of its countless special lending facilities, and fewer and fewer treasury bonds (the percentage of t-bonds has fallen from roughly 90% to a mere 22% of all assets held by the Fed).

As I have illustrated in this article that appeared at Mish's blog a while ago, this is a modern day update on the tally stick scheme.
The real 'backing' – the thing that ultimately stands behind all these promises – is the government's force monopoly, enforcing legal tender laws, the certainty that it will collect taxes in the form of this scrip and the fact that it accepts the scrip for payment of taxes (certainly no-one would accept irredeemable pieces of paper with ink slapped on them as 'money' in a true free market setting).

Investors have faith that the industrialized nation states will continue to be able to keep this scheme going, and that the possibility of government going bankrupt is remote – after all, there is a lot of accumulated wealth that can still be plundered, and also a reasonable expectation that in the long term, more wealth will be created (even though the process has met with a hitch for the moment, due to the bust that is now underway). This is certainly a reasonable expectation, based on historical experience.

However, this does certainly not mean that investors are completely discounting the possibility that the current monetary system itself could eventually fall into crisis. After all, what keeps it going is mainly confidence.
Should confidence in the system's viability evaporate, the only form of money still acceptable would be the one that is not a mere promise to pay – the money of last resort, gold.

A simmering crisis

I would in fact argue that signs of a simmering crisis of the fiat money system are increasingly in evidence. Take for instance the wild volatility of the fiat currencies relative to each other. It is as if capital were constantly fleeing from one corner of the burning building to the other (see the charts at the bottom).
Take the flight into government debt, that has taken on bubble-like characteristics. At one point last week t-bill discount rates briefly turned negative – investors were prepared to pay the treasury for the privilege of lending it money – of course, in reality they were paying the treasury for keeping their money 'safe'.

Consequently, Dr. Fekete does have a good point when he says that 'lasting backwardation in gold is tantamount to the realization that ‘gold is no longer for sale at any price’. (emphasis mine).
The important point is 'lasting' – the recent backwardation looked more like a short term aberration, a technicality basically, but was perhaps also a first warning shot regarding what may lie in store in the future.

Conclusion:

One should keep a close eye on the gold forward curve. Should a backwardation eventually become deep and entrenched, it would be a strong signal that the financial crisis has progressed to the point where the monetary system itself becomes the center of attention.

Below a number of charts illustrating the 'simmering crisis' situation. click on charts for larger images

currencies:

Wild gyrations in the Swiss Franc. As both a 'safe haven' and former carry trade currency, it is especially prone to sudden explosive moves.

The Yen has gone ballistic – this is the highest level since the 1995 spike high.

The dollar index – from overbought to oversold within days – the recent correction looks more like a crash than a correction actually. The recent moves in currencies are not indicative of a healthy system. One should add that these moves are exacerbated by the actions of trend-chasing quant funds, most of which usually tend to end up sitting on the same side of the boat just before it capsizes.

government debt:

The US treasury long bond - can you say 'buying panic'?

central bank data:

The sudden death of monetary prudence – base money is now growing at a 360% annualized rate

A longer term view. One can see both the Y2K monetary pumping panic (which gave us the blow-off phase of the Nasdaq bubble) and the post 9/11 spike. Both spikes used to really stand out on this chart as historical aberrations. No longer.

A few more charts from the Fed highlighting the situation.

GLD:

Gold holdings of GLD via Lance – a new all time high.

Hoover's heirs at work

noreply@blogger.com (pater tenebrarum) — Mon, 08 Dec 2008 07:16:00 +0000

A deepening global deflationary depression

No matter where one looks, the collapse in global economic activity and prices is astounding in its speed and ferocity.
A few examples, using manufacturing surveys, picked at random:

Between May and November, China's manufacturing PMI new orders index has crashed from 58,6 to 36,1.
The US manufacturing new orders index has meanwhile collapsed to a mere 27,9 – it stood at 54,3 as recently as July. The manufacturing PMI's prices component in the US has plunged from a 77 reading in August of this year to 25,5 in November, on the heels of the steepest decline in month-over-month headline inflation (deflation of 1% m-o-m) since the beginning of the CPI data series in 1947.
German new manufacturing orders have declined by 36,8% over just the past three months – with the most recent monthly contraction clocking in at an annualized pace of minus 48,2%.
In Japan, the PMI has declined to its lowest level on record – with the new orders index contracting to 27,3 from 44,1 a mere three months ago.

The litany of global woes is long, with emerging market economies on average in even worse shape than the industrialized nation economies, on account of their dependence on commodity exports, and incipient debt crises in response to collapsing currency values. The problem, as usual, is that too much debt was denominated in foreign currencies, which are now soaring against emerging market currencies.

Certain repeat default offenders like Argentina have seen credit default swap spreads on their sovereign debt soar to the stratosphere (5,000 basis points in Argentina's case – which is to say, it costs more than half of an Argentinian bond's face value to insure it against default for just one year).

One could list many more economic indicators that are indicative of a deepening and accelerating crisis, but the above selection gets the point as such across, so I'm not going to list all the data here. However, if readers are interested in all the horrid details, here are a few links where more information can be obtained: Haver Analytics and the Institute of Supply Management are both recommended sources of economic data and charts.

The extensive global division of labor, record global trade and capital flows , just-in-time inventory management and instant communication have seemingly conspired to instantly transmit an economic shock wave across the world. Note however that the difference to economic downturns of the past is only in the speed of transmission – the truly large busts have always gone global, only the lead and lag times may have been slightly different.

By now the fact that the yearly decline of the S&P 500 index has at one point in November been the worst ever seems rather normal, especially as the biggest part of the decline happened concurrently with the sharpest deterioration in economic activity (the stock market is not a leading indicator of anything – it has been a coincident and sometimes lagging economic indicator since at least 1998).

'Reflation' is a dud so far

Meanwhile the efforts of officialdom to 'reflate' are going absolutely nowhere. While the Federal Reserve has expanded base money at its fastest rate since the early 1930's, the broad money measure MZM (money of zero maturity) has remained static since March of 2008.
Merrill Lynch constructs a measure it calls 'money outside banks', by simply deducting base money from MZM - this is another way of illustrating that banks are taking all the 'free' money they get from the Fed and the treasury and have decided to simply hoard it.

Merrill Lynch's "money outside of banks" measure, deducting base money from MZM click on chart for larger image

This is not only due to the fact that bank lending standards have tightened considerably since the beginning of the year (as recent PMI surveys reveal, nearly half of the survey respondents reportedly had trouble obtaining financing) , but there is now also a dearth of willing and able borrowers - not counting desperate borrowers, many of whom fail to get credit precisely because of tighter credit standards.

A brief excursion into history – the monumental failures of the Hoover administration

The current situation is so far very much analogous to 1930-1932, years in which the Federal Reserve pumped up base money to an unheard of extent, increasing its balance sheet more than five-fold (!) over 36 months. It is important to keep this in mind , because the falsehood that the 1930's depression was so bad 'because the Fed failed to pump' keeps being widely accepted and bandied about. It is simply untrue.

In fact, one would do well to remember that when the 1930's depression started, absolutely no-one expected the downturn to turn into such a catastrophic economic wipe-out.
The general consensus was that:
1. the still relatively new-fangled Federal Reserve would be able to avert a deep economic downturn due to its 'flexible currency' and
2. that Hoover's new deal type policies would do the same. Hoovers 'new deal'? Yes, you read that right. All the policies that were later christened the 'New Deal' under the leftist FDR were initiated by the allegedly conservative Hoover.

Hoover was one of the first big believers in government interference in the economy who made it to the presidency. He was appointed secretary of commerce in the Republican Harding administration – Hoover had jumped to the Republican party from the Democrats in 1920, as he felt the Republicans would win.
He initially put himself forward as a presidential candidate , but failed in the primaries, and then half-heartedly endorsed Harding. Note in this context that both former navy secretary F.D. Roosevelt and W.W.1 president Woodrow Wilson actually had envisioned Hoover as a potential Democratic presidential candidate, but he jumped ship on account of his well-developed political instincts and an equally well-developed opportunism.

It seems likely that a combination of factors led to Hoover's appointment to the secretary of commerce post by president Harding in 1921 (a post which he kept under Coolidge).
On the one hand, the Republican party's left wing wanted to see him in a cabinet post, and for another, Harding had to reward him for his support.
Reportedly, Harding actually detested Hoover, who struck him as the very control freak he actually was.

The originally rather nondescript post of secretary of commerce soon became elevated by Hoover's numerous attempts to interfere in the economy. Hoover became known as 'the secretary of commerce and under-secretary of everything else' in Washington. Commerce appropriated responsibilities belonging to other cabinet departments when Hoover thought them 'neglected'.

However, the 'Hoover danger' was kept in check under Harding, who refused to bow to Hoover's demands during the 1921 recession. Harding was the last US president to endorse a 'laissez-faire' approach toward recession, a commendable attitude that had characterized policy under his 19th century predecessors as well.

Therefore, Hoover's proposal to initiate public works programs and keep wage rates artificially high was not followed in the 1921 recession, which helped keep the downturn mercifully brief. To be sure, the 1921 downturn was scary. The rest of Harding's cabinet however distrusted Hoover's ideas, and they turned out to be correct – the economy soon recovered of its own accord. Luckily Hoover did not get the chance to make things worse.

He did get the chance eight years later, when he began to preside over the first three years of the Great Depression. Similar to the often repeated falsehood of the Fed's 'passivity' in the face of the downturn, Hoover is nowadays often described as a paragon of free market policies , whose inaction was responsible for the giant economic bust. This is however merely statist propaganda designed to obscure the facts – spread by revisionist left-leaning historians.

Let's hear Hoover himself on the topic (from his memoirs):

“...the primary question at once arose as to whether the President and the Federal government should undertake to investigate and remedy the evils. . . . No President before had ever believed that there was a governmental responsibility in such cases. No matter what the urging on previous occasions, Presidents steadfastly had maintained that the Federal government was apart from such eruptions . . . therefore, we had to pioneer a new field.”

In April of 1930, as the stock market hit its post crash recovery highs, Hoover was generally hailed as having averted the depression. This was ascribed to his decisive actions in keeping wage rates high, initiating public work programs and farm supports.
He put pressure on the Federal Reserve to inflate, which initially met with some resistance from then governor of the board Roy Young. Young however relented, and later decided to resign in August of 1930. He was replaced by a more enthusiastic inflationist, Eugene Meyer.

In April of 1930, a round of back-patting by the interventionists, and glowingly optimistic forecasts of the imminent restoration of prosperity ensued – roughly similar to what we have seen in the months following the Bear Stearns rescue as it were, which was likewise marked by enthusiastic commentary in the press concerning the Federal Reserve's and the government's magical stimulus powers. See some of those comments here, here, here, here, and here.
Meyer really pushed the pedal to the metal, as the saying goes, and began to boost the Fed's securities holdings to an unprecedented extent, while slashing interest rates to 2% by the end of 1930.

By late 1930, the glow had however dimmed. Hoover, always a supporter of higher tariffs (one of his first actions as president was to hold a conference on tariffs – the conference was mainly concerned with how much to raise them in order to 'help' farmers), signed the Smoot-Hawley Tariff Act against the advice of almost every economist in the nation in mid 1930.
This piece of legislation abruptly aborted the brief stock market recovery – in a wave of panic selling, the market declined back to the 1929 crash low within a few weeks.
Nevertheless, Hoover felt the time for self-congratulation had come by October of 1930 (shortly before the stock market broke to even lower levels):

“I determined that it was my duty, even without precedent, to call upon the business of the country for coordinated and constructive action to resist the forces of disintegration. The business community, the bankers, labor, and the government have cooperated in wider spread measures of mitigation than have ever been attempted before. Our bankers and the reserve system have carried the country through the credit . . . storm without impairment. Our leading business concerns have sustained wages, have distributed employment, have expedited heavy construction. The Government has expanded public works, assisted in credit to agriculture, and has restricted immigration. These measures have maintained a higher degree of consumption than would otherwise have been the case. They have thus prevented a large measure of unemployment. . . . Our present experience in relief should form the basis of even more amplified plans in the future. “

Does this sound like a proponent of 'laissez-faire' to anyone? I didn't think so.

Hoover's method was to get big business to 'co-operate' with his plans, by threatening to make his plans compulsory via legislation. Also, there was a curious swing toward leftist policies in big business circles themselves in the early 30's. The natural enemies of central economic planning became curiously enamored of such socialist ideas (see the 'Swope plan' hatched by the then CEO of General Electric, which proposed a fascist cartelization of US industry, and was enthusiastically supported by the chamber of commerce).

1931 turned into a catastrophic year, with all indicators of economic activity plunging further. This spurred even more interventionism on both the administration's and the Federal Reserve's part.
Note that the money supply actually contracted in spite of the Federal Reserve studiously blowing up monetary reserves under its control.

There were several reasons for this. For one thing, the public – rightly – mistrusted the banking system, and began to withdraw deposits, converting them to cash. Cash in circulation accordingly actually rose significantly, but bank reserves not under the Fed's control declined still faster than the Fed could pump – as bankers themselves had ceased to trust each other (this sounds vaguely familiar, does it not?), and feared bank runs by depositors. Naturally the fractionally reserved banks all knew that none of them could withstand such a run, and so eyed each other with distrust.

Note in this context the following ominous recent chart:

Currency in circulation has suddenly begun to rise sharply from mid 2008 - the same happened in 1931-1932, as the public , increasingly wary of the banks, started to convert deposits into cash. click on chart for larger image

Furthermore, the banks saw no reason to extend new credit or buy securities. They rightly feared that such lending would expose them to more default risk, and they wanted to reassure rather than frighten their depositors. One of the decisive factors in this were the Fed's and the administration's attempts to prevent a liquidation of unsound credit by all means.
Needless to say, what the modern-day Federal Reserve is doing today amounts to exactly the same – by taking impaired mortgage securities off the banks books, it likewise prevents the liquidation of unsound credit. For reasons no-one has as of yet deigned to explain, this is somehow supposed to work better nowadays than it did in the 1930's.

Hoover forced the banks (with his usual 'co-operate or i'll legislate' threat) to agree to forming the NCC (National Credit Corporation), whose purpose it was to have the strong banks shore up the weak ones (sound familiar? It should).
The Banks contributed $500m. in capital, and the NCC could borrow up to $1bn. from the Federal Reserve (then enormous amounts).
He then hatched the plan to start a state-owned lending agency, the Reconstruction Finance Corporation (RFC), that was to lend to needy banks and businesses, and was intended to become the successor of the NCC. Hoover also leaned on mortgage lenders to delay foreclosures.

His late 1931 plans – to be enacted in 1932 – also included the formation of the Federal Home Loan Bank System, that would be able to discount mortgages and would be backstopped by the government and the Fed , and a vast expansion of the already vast public works program.

A note about the RFC: it was decided that it should be kept secret which organizations and banks received RFC loans , in order to 'avoid a weakening of public confidence' in such firms or banks (not surprisingly, the stench of corruption soon enveloped the RFC).
This is analogous to the Bernanke Fed refusing to disclose the precise nature of the mortgage assets it has bought from the banks – in spite of the fact that the tax payers are the involuntary owners of these assets, they are not to know what is being done with their money.

Interestingly, in 1931 the Fed provided large lines of credit to foreign governments as the crisis became acute in Europe as well (the UK and Germany were large recipients of such aid, and Austria and Hungary received somewhat smaller amounts)– shoring up their unsound credit positions as well ('unlimited swap lines' to foreign central banks anyone?).

As classical economists later argued, this contributed to growing mistrust in the dollar, and a consequent outflow of gold from the US. Since European governments, with Britain in the forefront, abandoned the gold exchange standard (not a true gold standard anymore), it was feared that the US may not be far behind. In late 1931, the Fed briefly hiked rates to reverse this outflow of gold, but this policy reversal didn't last long.
In the final quarter of 1931, the money stock collapsed by $4 billion in spite of the Federal Reserve leaning against the wind with large reserves increases, as cash in circulation exploded by $400 million – the public kept withdrawing deposits from the banks as confidence plummeted.

From early 1932 onward, the Fed continued with a massively inflationary policy, forcing interest rates down and expanding reserves under its control by large amounts. This further reduced the incentive for banks to actually lend out money – since the risks were high, they would have at the very least needed high interest rates to compensate for those risks, but the Fed created the exact opposite rate environment.
Furthermore, the Fed was still unable to prevent a fall in the money supply, although one would have normally expected its actions to lead to a large increase of same.

The banks and the public both kept the 'monetary transmission mechanism' perfectly broken. Cash in circulation continued to increase sharply, and reserves not under the Fed's control continued to fall faster than it could expand the ones it did control.
Hoover constantly railed against bankers' unwillingness to lend – specifically, he complained that his version of the TARP, the RFC (which eventually grew to 8 times its original size!), bolstered bank capital, but banks would still not inflate credit! Does this not also sound familiar? Barney Franks, actually most of Congress, is making exactly the same complaint these days.

It is worthy of note that under Hoover, government's share of the economy grew mightily, as Hoover produced the by far largest peace-time deficit the US had ever experienced up to that point (this is to say, not only in absolute but also relative terms compared to GDP). This alone should disarm anyone who pretends that Hoover favored a free market approach – not only did government revenue dwindle, but expenditures shot up in unprecedented fashion. In the 1932 presidential campaign none other than Franklin D. Roosevelt accused Hoover of being an 'unconscionable spendthrift'(!), while his running mate, John Garner accused Hoover of 'leading the country down the path of socialism'. They were of course correct, but it clearly was a case of the kettle calling the pot black.

Hoover's follies didn't end there.
Faced with a growing deficit, he unwisely concluded that the time for raising taxes had come. Obama-like, he thought it was a good idea to soak the rich, an idea FDR later enthusiastically expanded upon. Conservative, 'free market' Hoover raised the normal tax rate from a range of 1-5% to 4-8% and the top marginal tax rate from 25 to 63%. He also introduced a sales tax on a large number of products and services (including postal rates), raised the corporate tax rate by 1%, doubled the estate tax, restored the gift tax (at 33%) and eliminated a range of exemptions and tax credits.

Then he pushed the New York Stock Exchange into restricting short selling by February 1932 – a witch hunt was started in the form of a Senate investigation of the exchange and various 'sinister pools of bear raiders' who allegedly 'forced securities below their true value' (as Hoover himself put it).
Does this also sound familiar? It should. This is precisely the argument used by the SEC chairman Cox when he restricted short selling of financial stocks just prior to the October market crash.

Will it surprise you to learn that after Hoover had successfully bullied the exchange to outlaw short-selling that the DJIA suffered its biggest downturn of the entire 1929-1932 bear market?
The market declined by 65% from the enactment of the restriction to its eventual low in the summer of 1932. Maybe SEC chairman Cox should have taken a brief look at the effects of this historical short selling ban before engaging in the same folly.

Why Hoover's modern-day heirs will fail

The above historical information is largely sourced from Murray Rothbard's book 'America's Great Depression' , which I encourage everyone to read. It can be downloaded for free here(pdf).

The purpose of recounting the historical depression episode is to point out the many parallels that already exist between the interventions government enacted back then and those it is enacting now. Specifically, the artificial preservation of unsound credit and malinvested capital , coupled with grand plans to 'invest in infrastructure' (public works) and enact other types of 'stimulus spending' are eerily similar.

The things the Bernanke Fed and the treasury are doing are very similar to the things the Meyer-led Fed and the RFC engaged in – and it is encountering precisely the same problems. Banks are unwilling to lend, and borrowers are unwilling or unable to borrow, so a theoretically highly inflationary expansion of the money base and the Fed's balance sheet has so far failed to entice any broader inflationary effects.

Meanwhile the activities of the GSEs Fannie Mae and Freddie Mac under 'conservatorship' , whereby they have begun to once again expand their balance sheets in spite of the fact that this is obviously economically unsound (they keep producing record losses for one thing) and various government plans to prevent foreclosures and 'persuade' creditors to weaken their claims by threatening them with the requisite legislation, are likewise reminiscent of the same approaches during Hoover's administration.
Hoover's RFC is a close cousin to Paulson's TARP – it did essentially the same thing, namely provide government money to weak banks.

Obama meanwhile proposes to actually raise the minimum wage – which is reminiscent of Hoover's policy of preventing wage rates from falling in alignment with other prices. This policy practically guarantees rising unemployment.

The 1920's boom that led to the sharp increase in malinvestment that eventually produced the bust, was a boom during which 'stable prices' were a central Fed policy, just as they have been throughout the 1990's and the 2000's.
Thus, a large increase in economic productivity allowed the Fed to inflate the money supply willy-nilly, which prevented the fall in the general price level that would have occurred absent such inflation.

The policy of 'stable prices' was in reality a policy of inflation, and allowed the other effects of inflation, chiefly the amassing of malinvestments and the creation of artificial, non-wealth generating activities, to proliferate.
Furthermore, while the general price level appeared stable both in the 1920's boom under Benjamin Strong and the modern day boom mostly under Alan Greenspan , securities and real estate prices increased sharply, encouraging the credit boom further (whereby rising collateral values formed the basis for more credit creation).

Another feature of both booms was that consumer credit exploded, with consumers lulled into complacency by the seeming 'soundness' of their balance sheets.
The ensuing consumption boom is precisely what damaged the economy's production structure in both cases, by misleading business-men about sustainable levels of demand. The expansion in credit increasingly encouraged exchanges of 'something' (real resources and goods) for 'nothing' (money out of thin air, created by the Fed and the fractionally reserved banking system), depleting the pool of real funding while the respective booms proceeded.

One thing that is different today is that the Fed has become even more 'flexible', its currency even more 'elastic'.
Hoover never intended to abandon the gold standard – this was a step too far even for him.
The modern-day Fed has no such restraints to worry about. Note in this context that what we have heard from the horse's mouth – Bernanke himself – regarding possible Fed actions to 'combat deflation' is absolutely hair-raising stuff. Over half of these suggestions have already been implemented (the following quotes are from his famous speech “Deflation: Making Sure "It" Doesn't Happen Here” :

“The Fed must expand the scale of its asset purchases or, possibly, expand
the menu of assets that it buys.”
“The Fed could find other ways of injecting money into the system–for
example, by making low-interest-rate loans to banks.” He notes the Fed
could “offer fixed-term loans to banks at low or zero interest, with a wide
range of private assets (including, among others, corporate bonds,
commercial paper, bank loans, and mortgages) deemed eligible as
collateral.”
“The government could…acquire existing real or financial assets.”
“If the Treasury issued debt to purchase private assets and the Fed then
purchased an equal amount of Treasury debt with newly created money, the
whole operation would be the economic equivalent of direct open-market
operations in private assets.”
“Lowering rates further out along the Treasury term structure” either by
“holding the overnight rate at zero for some specified period” or by using a
“more direct method, which I [Bernanke] personally prefer” would be to
announce “explicit ceilings for yields on longer-maturity Treasury debt.”

In other words, the Fed must inflate at all costs, precisely when the economy needs the opposite. Naturally it makes no sense whatsoever to attempt to keep malinvested capital in place and create additional malinvestments on top of it.
There is a natural limitation to all the governmental efforts to 'reflate' in the form of the economy's subsistence fund. Its size is finite, and it has been weakened by the previous large credit expansion. Remember that 'money out of thin air' allows people and businesses to bid for resources and goods without first producing any resources themselves. This by necessity must weaken those sectors of the economy that actually produce wealth, since they have to compete for these resources.

Furthermore, what the government is doing is to merely redistribute existing resources when it enacts 'economic stimulus' packages and 'public works' programs. It is irrelevant how worthy some bureaucrat with incomplete information deems a certain infrastructure spending project to be – the fact remains that the resources employed in this state-directed spending must be removed from where they are employed prior to such state-directed spending.

The government has three possibilities to raise funds to engage in its spending: it can tax, it can borrow, and/or it can print money.

The former two amount to a straightforward redirection of existing resources from a market-based allocation process to a government-directed one. The only way this could possibly be beneficial would be if we actually believed that government directed resource allocation process is to be preferred over the market-directed one, because it has been proven beyond the shadow of doubt that government bureaucrats are better at this than the market.
If one believes that, it would be time to cast a quick glance toward North Korea to see what happens when government is the only agency engaged in resource allocation (It is no coincidence that a complete takeover of the economy by government is only possible in conjunction with a terrible tyranny).

The third possibility, namely a policy of inflation, i.e. of printing money out of thin air (Bernanke's department), can obviously only lead to more of the same that has actually brought us to this juncture: a misallocation of resources and consumption of scarce capital as the pool of real funding sustains further damage.
It is to be expected that the policy of inflation, which is now being openly pursued (the Fed admits that its mooted, $800bn. purchase of MBS and ABS, which has begun last week, will 'add to bank reserve assets' - in other words it amounts to outright monetization, euphemistically known as 'quantitative easing'), will continue to flounder for a good while as capital-impaired banks refuse to lend money in view of the heightened risks of doing so.

At the same time, the massive 'guarantees' (such guarantees are only worth something as long as not too many people call on their fulfillment at once) provided by the FDIC have made the prospect of bank runs a fairly remote one, so an important check on banker recklessness does effectively not exist, or is severely weakened.

In addition, it can already be gleaned from Bernanke's comments that a much greater monetization effort (of 'private assets' which the treasury buys via the Fed monetizing treasury debt) would eventually ensue should the current efforts continue to fail in igniting 're'-inflation.

So the possibility that wider inflationary effects eventually become visible in the data (via growth in broader money supply measures re-accelerating) can not be ruled out. While the traditional modus operandi, whereby the Fed 'transmits' its monetary pumping via the commercial banks lending and creating new deposits, that then are re-lent, ad infinitum (the famous 'money multiplier') may continue to fail just as it has in the 1930's, the non-traditional methods may well meet with 'success' (if you define success as doing more damage to the economy's production structure, that is). This largely depends on the central bank's determination.

Wealth can of course not be increased by one iota through such efforts – if and when more money units circulate, the existing money units become worth less, and the many negative consequences of an inflationary policy manifest themselves.

The economic bust, and the – current - deflationary manifestations of this bust, are necessary to liquidate and redirect malinvested capital. Keeping such malinvested capital on artificial life support leads as we have seen to nothing but unintended consequences. This is why the massive interventions already implemented and those yet to come are doomed to fail and actually are a very good reason to remain pessimistic about the future.
Contrary to what Bernanke claims, it is not the sudden frugality of consumers that has 'created the recession' - it is the damage done to the economy's production structure that is at fault, and this has been a consequence of previous policies that furthered too much (unbacked) consumption.

It makes no sense for government to try to avert the liquidation of unsound credit positions. This will only prolong the misery, as banks continue to have every reason in the world to distrust both each other as well as the economy's capacity to right itself.

Finally, the fall in prices that has recently occurred, is actually a small reason for hope, as Lew Rockwell points out here. There is no good reason to try to prevent it , as is claimed by the government.

Credit stress continues

noreply@blogger.com (pater tenebrarum) — Thu, 04 Dec 2008 12:39:00 +0000

As the Financial Times Alphaville blog reports here, the credit markets continue to be under great pressure.
Specifically, the European high yield CDS benchmark iTraxx crossover, which tracks credit default swap spreads on European junk bond issuers, broke through the 1000 basis points barrier for the first time.

The I-Traxx crossover index of European corporate junk bond CDS Click on chart for larger image

Concerns over corporate solvency continue to mushroom, especially as it is not quite clear how easy it will be for junk bond issuers to roll over debt in the current climate. It seems in fact quite likely that a number of bankruptcies will be triggered by such failures to roll over debt.

Credit spreads on corporate debt have generally made yet another explosive move higher, as treasury yields have imploded in the recent blow-off move in government notes and bonds. Note in this context that we have once again a case of 'unintended consequences' at work here, as the implosion in treasury yields can be attributed directly to the Fed's decision to montize $800 bn. in MBS and ABS, forcing duration hedging of large MBS portfolios.

The current junk bond spread over treasuries indicates a 21% default rate of junk borrowers over the coming year, which is quite extraordinary.

The Barron's confidence index is also making new lows - this index is a ratio chart comparing a high grade with an intermediate grade corporate bond index. When it falls, it means that lower graded bonds are falling in price relative to higher grade bonds. The collapse in this index is nothing short of astounding. Once again, the only (relatively nearby) historical period with which the current situation can be compared is the 1929-1932 collapse.

the Barron's confidence index, courtesy of sharelynx click on chart for larger image

Thus one has to still tread very carefully in the stock market as well, even though it is technically more than ripe for a good bounce. As Monday's 8,9% one day crash in the SPX has shown, extremely large sell-offs coming seemingly out of the blue have to be expected at any time. It is the continued deterioration in credit markets that is triggering these bouts of short term plunges in the stock market.

Here is a very useful bookmark, showing a table of all corporate CDS index spreads published and administered by Markit. One should keep a close eye on future developments in these index spreads.

We are not 'all dead in the long run'

noreply@blogger.com (pater tenebrarum) — Wed, 03 Dec 2008 02:00:00 +0000

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.

Gold stocks and the stock market – an update

noreply@blogger.com (pater tenebrarum) — Fri, 28 Nov 2008 04:59:00 +0000

1. Gold Stocks

Since my last look at the gold stocks the sector has rallied sharply - along with the broader equity market, but with a number of notable differences, mainly in terms of leads and lags and relative performance.

As noted in the original post on gold stocks, a strange dichotomy had developed at the time, insofar as the gold/SPX ratio was rising, whereas, oddly, the HUI/SPX ratio was falling concurrently. Shortly after i pointed this out, this trend began to change again in favor of the gold stocks.

The HUI produced a divergent, higher low in November, just as the SPX broke to a new multi-year low in the wake of the previously documented collapse in commercial mortgage backed debt. Furthermore, the HUI has already managed to exceed its secondary late October high, a feat as of yet proving elusive for the SPX.
Since the low was put in, the HUI index has sharply outperformed the SPX, bringing the ratio between the two back to a less 'abnormal' level, although not yet to a level that would be justified by the concurrent multi-year highs in the Gold/SPX ratio.

The rational expectation would therefore be for the recent streak of gold sector outperformance to continue. This idea is additionally supported by the fact that the gold/oil and the gold/commodities ratio have kept rising vigorously as well.
As noted before, this is very important for the profit margins of the gold mining industry, due to energy representing its second biggest input cost factor after labor; other commodity input prices (for instance steel, timber and rubber) are also relevant to gold mining margins.
A large divergence between the current valuation of gold stocks, and gold's real price (which remains at multi-year highs) thus persists. Even if the nominal gold price were to remain static or were to soften somewhat, gold stocks would remain historically very undervalued at current levels.

Obviously the gold sector has crashed along with the rest of the stock market in October for reasons that have nothing or little to do with its fundamental outlook (an argument could be made that fear of deflation played a role in the HUI's relative weakness during October, but this doesn't satisfactorily explain the contrast between gold's relative strength and the relative weakness of gold stocks).
Forced liquidation swept everything along, regardless of relative values. Ironically, the fact that the gold sector is comparatively illiquid meant that it was undeservedly punished with extraordinary severity.
Note however that declines of similar severity happened during previous bull markets in gold stocks as well – the extent of the decline is per se not proof that the long term bull market is over – prima facie it just represents a large cyclical bear market that was unusually compressed in time.

No doubt the sector will continue to be buffeted by recurring deflation fears and the countervailing uncertainties introduced by the ongoing monetary pumping exercises of the central banks.
The markets clearly fear that a deflationary spiral could overwhelm the system, as credit creation by the commercial banking system has ground to a halt, at the same time though, the central banks and fiscal authorities are engaged in the biggest reflation effort ever attempted in the history of the recurrent crises of the modern system of irredeemable currency.
The attempt to recreate the inflationary phantom wealth of the boom is likely doomed to failure (aside from the fact that it makes little sense), but a properly determined central bank operating in a fiat money system can always devalue the money it issues – just ask Dr. Gideon Gono if you don't believe it.
However, regardless of whether these inflationary measures do or do not 'succeed', gold will likely prove to be a good hedge hedge against both outcomes – since both will be marked by 'monetary disorder'.

It remains to be seen if the gold sector is merely going to continue to mimic the larger stock market's moves with a higher beta , or if it eventually manages to decouple and go its own way again, as it did in the 2000-2002 bust. This likely depends on the intensity of prospective recurring liquidation periods.
In the heretofore grand-daddy of deflationary super cycle bear markets of the 1930's, gold stocks crashed with the market in the initial crash wave, but later decoupled and were the only market sector to produce large gains.
It has been argued that the at the time fixed gold price made this possible, but a similar argument could be made now, since the core of the argument is not about whether the price of gold is fixed, but whether gold actually gains in terms of purchasing power.

A note on the gold/CRB ratio: gold has literally exploded against the CRB. It is fairly typical to see gold's price in terms of commodities rise sharply during economic busts, but the extent and speed of this recent rise are indicating that the current bust is a secular one of a very high degree.

Bob Prechter argues it is in fact what he calls a 'grand super cycle degree bear market' – read: a bust that corrects the entire economic advance since 1720. This idea is based on the fractal nature of the stock market described by the Elliott wave system (all types of waves repeat at various cycle degrees – and indeed, one can look at a one minute chart of the stock market and detect up and down waves that have an astonishing similarity to the hourly, daily, weekly, monthly, etc. waves; the stock market clearly exhibits a fractal structure).

I for one think it is difficult to come to a firm conclusion about such extremely large degree waves, because one can easily be off by decades timing-wise, and will only ever know for sure in hindsight , provided one lives long enough.
Bob Prechter bases his view on his long term Elliott wave count of the stock market, but even at very large degrees, such a count can end up in need of revision at a later stage (it has already happened to some extent to his count – the 5th wave of the bull market kept extending).
Regardless though if his dire outlook is correct, we do know one thing for sure: it is a secular downturn, and as such at least of super cycle degree – for the stock market, it means a journey from extreme overvaluation (year 2000) to extreme undervaluation (by 2010 -2014 perhaps?).

This makes the gold sector very interesting, for the simple reason that while it often correlates positively with the rest of the market over the short to medium term, it has a proven negative long term correlation with the broader stock market.

Note though that in the near term, gold itself still needs to overcome a number of technical hurdles – namely resistance in the $830-845 area, and then the major resistance around $925-930. Gold's market structure (in terms of commitments of traders in the COMEX futures) looks quite bullish of late, as small speculators hold an exceedingly small net long position. From this standpoint, it should be easier to overcome resistance than it has been on occasion of the last attempt, but there is no guarantee it will happen.

Charts:

1. The HUI index and its divergent secondary low; several potential technical resistance points are denoted that may have bearing on short term trading tactics. Click on chart for larger image.

2.The HUI/SPX ratio has turned again in favor of the HUI, and is now in 'mid point' territory. Click on chart for larger image.

3.The gold/SPX ratio continues to cling to multi-year highs. Click on chart for larger image.

4.The gold/oil ratio has risen back to its long term average, at the same time a near 8-year high. Click on chart for larger image.

5.The gold/CRB ratio is yet another way of showing that gold's purchasing power has massively increased, in spite of the fact that its nominal price is a good deal below the all time high of March. Click on chart for larger image.

6.The nominal gold price must overcome two major resistance levels to confirm a new uptrend. Click on chart for larger image.

2.The Stock Market

I previously pointed out that the market was likely close to a low in terms of time, as during the last update, wave 5 of 3 was clearly underway. It appears now that wave 5 likely ended at the November 20 low, concurrent with the blow-off moves in mortgage and junk debt yields. In my opinion, it is quite worrisome from a longer term perspective that the market at one point sliced through the lows of 2002 as if they weren't there, but short term this slight undercutting of an old low followed by a reversal back above it is likely a positive sign – at least it should be given a positive weight when looking at the entire probabilistic gestalt.

After i posted the worrisome charts of Citigroup and the BKX, both continued to collapse , C for two more days and the BKX for one more day, whereby their moves down , while short lived, where absolutely astounding in terms of their severity. By the time the market closed on Thursday last week, it appeared as though we were once again on the brink of a true systemic meltdown. Everybody knew that someone had to be hurting big time from the plunge in mortgage backed and corporate debt, and it was equally clear that 'too big to fail' Citigroup was at the center of storm this time.

Friday then brought a late day relief rally that the financial press ascribed to president-elect Obama appointing Tim Geithner to the post of treasury secretary (certain sharp-tongued cynics who want to remain anonymous remarked that 'the nomination of anyone but Paulson would likely have produced a rally; even a block of wood would have done – at least one could be sure that it would remain silent').
This 'explanation' makes no sense however, since Geithner is closely associated with the bunch of nincompoops who 'never saw it coming'. 'It' being the current financial and economic disaster.
Besides, anyone who still believes that politicians matter in the face of this tsunami of a bearish social mood turn and collapsing credit bubble should best keep away from the stock market for his own good.

A more sensible explanation is actually that it was an options expiration, which saw market makers buy back their shorts in the last half hour (when option market makers sell puts, they hedge by shorting the underlying shares – once those puts expire, the hedges are lifted).
The Elliott wave explanation would be: wave 5 was likely finished, regardless of the technicalities surrounding the event.

However: whereas broader indexes like the SPX and the NYA have clearly made it back above their October lows, the BKX is actually still lagging - in spite of rising over 50% (!) from its intra-day low on Friday last week, it has yet to make it back above the broken neckline of the head and shoulders formation i pointed out.
If there is anything that makes me doubt the 'wave 5 is finished' idea, then it is this fact. It is the single most worrisome fact to my mind, in terms of the overall technical picture.

Yes, the interventionists succeeded in lifting a great weight off the market's mind in the short term, by first agreeing to backstop Citigroup with guarantees amounting to over $300 billion – a move designed to avert the growing danger of a run on the bank (of the total of $820 billion on deposit at Citi, a huge $554 billion was/is held abroad – and thus not subject to FDIC insurance. No doubt these foreign depositors were going to form queues at Citi branches worldwide come Monday, had the government not decided to bail the bank out for all practical purposes), and secondly by announcing an enormous additional monetary pumping exercise that appears to amount to an outright monetization of $800 billion in 'highly rated' mortgage backed and asset backed securities.

Consequently, CDS markets calmed down considerably, and credit spreads declined left and right. Most notably, CDS spreads on Citi's debt were basically cut in half (while this was no doubt a great relief to almost everyone, there are losers in this type of trade as well – and it is actually a bit infuriating that those who made the correct bet – namely that the creditworthiness of Citigroup was increasingly in doubt – were once again cheated of their winnings by a government intervention. I note that there is no great urge anywhere to make their losses good).

The fact remains though – the BKX index is still below its broken neckline. My advice would be to watch very closely what happens once it touches the neckline, which should be within a trading day or two. If it turns back down from there, we can go back to 'red alert' status in my opinion.

The second item that needs to be considered is the fact that yields on longer dated government debt continue to decline sharply. In part this is due to a technicality – the government's recently announced hoovering up of $800 bn. in MBS and ABS has created prepayment risk for mortgages – and that means that a number of MBS portfolios are likely to get a duration mismatch problem, or rather, the previously extant duration mismatch problem has been reversed in the opposite direction (rising mortgage rates lengthened the expected maturities and durations of MBS portfolios, falling mortgage rates will shorten them). Hedging against the eventuality of shortening or lengthening durations is done in the treasury bond and note markets, and currently this is driving yields lower.

However, t-bonds and notes have normally also a strong tendency to confirm stock market rallies by means of declining (i.e., yields rise) – in that sense, their recent action constitutes a non-confirmation.
Note also, with t-bill rates close to zero and other short term rates having declined precipitously as well, this recent move at the long end of the curve actually flattens the yield curve – this is can not be considered a good sign for the 'reflation' effort.

Lastly, on the potentially positive side of the ledger, we have the recent weakening of the dollar index (DXY), which has happened against a backdrop of technical divergences at the recent high. It may finally be due to correct, a fact that is supported by gold strength leading the subsequent weakness in DXY. A large correction in DXY would likely accompany a wave 4 rally in stocks, given their recent strongly negative correlation (a rising DXY and Yen are symptoms of deleveraging).

Summary:

While the recent rebound in stocks suggests the large wave 4 retracement may finally be underway now, there are still important non-confirmations extant. It is always possible that the confirmations will happen with a slight lag, however, one should keep a close eye on what actually develops. The previous warnings regarding the overall sentiment picture remain in force – however, there always comes a point when previously shaken fund managers go from praying for a rally to fearing they might miss one, and such a flip of the herd will eventually produce the retracement rally in self-fulfilling prophecy fashion.
The short term risks seem a lot lower than they were exactly one week ago, but they have by no means disappeared.

Charts:

1.The SPX is back in the 'zone' for now. Click on chart for larger image.

2.The BKX has yet to get back above its broken neckline, in spite of an enormous rally off the recent low. Click on chart for larger image.

3.The long bond is not yet confirming the rally in stocks. Click on chart for larger image.

4. DXY has recently weakened after a high with typical 'end of move' divergences in evidence. It may be a bit early to tell, but a larger correction seems definitely possible. This would be an important development for all risk assets. Click on chart for larger image

charts via stockcharts.com

Spitting in the wind, Zimbabwe, and Baghdad Hank's financial perpetuum mobile

noreply@blogger.com (pater tenebrarum) — Thu, 27 Nov 2008 02:00:00 +0000

Bloomberg today reports 'Fed Risks ‘Spitting in the Wind’ With New Aid Pledges'. This is in the context of the most recent addition of alphabet soup monetary pumping measures (amounting to a cool $800 billion), which apparently will monetize a good chunk of MBS and ABS.
These, as has been widely reported, bring the total of government backed pledges aiming to save capitalism from itself by destroying it to $8,5 trillion.

Yes, that's trillion with a 'T'.
Take heart though dear reader: as the Reserve Bank of Zimbabwe reports here, recently, fraudulent checks amounting to Z$ 60 hexillion (yes, that's hexillion with an 'H') were 'intercepted' in Zimbabwe in the 10-day period from November 10 to Novermber 20.

A hexillion isn't as bad as it sounds. This is the Greek name for what English-speaking people normally know as the generally more harmless sounding quintillion, which is only 1000 quadrillions, or 1 million trillions. So in ten days, checks for 60 times 10 to the power of 18 Zim-dollars sorta bounced. And you thought we had a problem!

The governor of Zimbabwe's Reserve Bank, Dr. Gideon Gono, a kind of Baghdad Bob of central banking, is understandably incensed.
Evil stock market traders are pushing stocks up by 2 million percent a day , and that, so he says, 'creates inflation'.
Who would have thought!
He knows it though - it's simple enough: " This clearly dwarfs the $1.1 hexillion making up 100% of all the quasi-fiscal operations the Reserve Bank engaged in over the past 5 years."
See? They only printed up 1,1 hexillion!
There is a very good reason for that, which is helpfully supplied as well in the document: "The Reserve Bank cannot miraculously stretch existing National Printing capacity beyond the fixed physical levels that are in place over the short term."

Read: "We ran out of paper and ink" - always a good first step toward stopping inflation in its tracks one supposes (if not for those evil stock market traders, that is).

One can already imagine the press releases a month or two from now: "We only printed up 1 googolplex of Zimdollars, not 10!"

Here is what Dr. Gono recently had to say about the actions the Fed and other Western central banks have taken (he really said that):

"As Monetary Authorities, we have been humbled and have taken heart in the realization that some leading Central Banks, including those in the USA and the UK, are now not just talking of, but also actually implementing flexible and pragmatic central bank support programmes where these are deemed necessary in their National interests.

...That is precisely the path that we began over 4 years ago in pursuit of our national interest and we have not wavered on that critical path despite the untold misunderstanding, vilification, and demonization we have endured from across the political divide. [Bold in original]

...Here in Zimbabwe we had our near-bank failures a few years ago and we responded by providing the affected Banks with the Troubled Bank Fund (TBF) for which we were heavily criticized even by some multi-lateral institutions who today are silent when the Central Banks of UK and USA are going the same way and doing the same thing under very similar circumstances thereby continuing the unfortunate hypocrisy that what’s good for goose is not good for the gander.

...As Monetary Authorities, we commend those of our peers, the world over, who have now seen the light on the need for the adoption of flexible and practical interventions and support to key sectors of the economy when faced with unusual circumstances."

As a friend remarked via e-mail, this is akin to being commended on your human rights record by Hitler or Stalin.

Bloomberg's colorfully titled article on the Fed's most recent monetary contortions meanwhile contains an absolute gem by Hank Paulson, who is apparently also vying for the Baghdad Bob title...you know, the Baghdad Bob of treasury secretaries.

We all fondly remember his " This is far and away the strongest global economy I've seen in my business lifetime," declaration of July 2007, which heralded the fact that everything was about to go down the financial toilet real fast, as well as his often repeated "the subprime crisis is well contained" mantra, and his bold assertion that "our financial institutions entered this period well-capitalized, and we expect them to remain so,".

Some would say that taken together, these and other Hank bonmots uttered in the course of what is nowadays known as the 'biggest financial crisis since the Great Depression' (formerly know as the 'far and away strongest economy'), should actually suffice to earn him the Baghdad Hank moniker, but he really cinches it with this:

"Treasury Secretary Henry Paulson said the mortgage debt purchases are a “great investment for the taxpayer” because the government already stands behind Fannie and Freddie."

One wonders why nobody has thought of this before - why does the government only now realize what great deals it can make for tax payers?
They could have been doing these great deals for years already, and we'd all be rich by now!
Can't you see the quintillions dancing before your eyes?
In a masterstroke, Hank has invented the financial equivalent of the perpetuum mobile! He's a...i don't know, a financial William Sommerset perhaps?

My personal guess though is that Orwell's 1984 dictionary has been updated.
The new entry, courtesy of Hank 'Baghdad Bob' Paulson, the new Marquis of Worcester:

Loss is profit!

See, buying these crappy bonds is really a good business for you, because we guarantee them already in your name.

It appears that as a busy interventionist, one soon develops circular logic syndrome. It is not certain yet if the affliction can be treated.

the original Baghdad Bob and his worthy successors, the Baghdad Bob of central banking, Dr.Gideon Gono, and the Baghdad Bob of treasury secretaries, Hank Paulson:

Going shopping in Zimbabwe (Photo credit: Tsvangirayi Mukwazhi / AP):

Why the stock market keeps plunging

noreply@blogger.com (pater tenebrarum) — Thu, 20 Nov 2008 02:37:00 +0000

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.

A little housekeeping note

noreply@blogger.com (pater tenebrarum) — Mon, 17 Nov 2008 04:53:00 +0000

First of all, i have belatedly issued replies to some of the comments made by readers thus far. I will always eventually read all comments, and reply to questions as good as i can. However, i can only do this as time permits, so if nothing comes forth immediately, you may want to check after a little while again.

Secondly, i want to point readers to this excellent article by George Reismann, which concerns the topic i have talked about in the 'A Failure of Capitalism?' post.

It can be found here: 'The Myth that Laissez Faire Is Responsible for Our Present Crisis' by George Reismann.

There have recently been several other very good articles at the Mises Institute that i encourage readers to check out, as they concern some of the things discussed in my posts.

Here is an excellent, easy-to-grasp primer on Capital Theory:

'The Importance of Capital Theory' by Robert P. Murphy

and here, Frank Shostak asks 'Do we need more of Keynes now?', a brief, but effective denunciation of the Keynesian economic framework.

The collapsing value of mortgage debt and the stock market

noreply@blogger.com (pater tenebrarum) — Mon, 17 Nov 2008 02:26:00 +0000

The stock market has recently been as 'oversold' as it normally ever gets – in fact, some of the market's internals have produced never before seen records (on one occasion in early October, new lows at the NYSE jumped to almost 2900 issues, which is almost thrice the previous record high; last Thursday the NYSE TICK at one stage in the early day sell-off was recorded at minus 1940, a new record low, to name two examples. It almost doesn't matter which indicators one looks at – they have either produced never before seen extremes, or extremes that were last seen in 1929-1932).

Many of these internals have recently 'eased off', and on Thursday's 'classic retest of the lows' we see numerous divergences (fewer new lows, a lower VIX, lower put/call ratios, a higher RSI reading, a higher MACD reading, etc, etc.) that would normally lead one to expect that some sort of larger relief rally is close at hand.

And yet, there remain a number of flies in the ointment.

Bulls and Bears

The first one is the apparent eagerness of traders wanting to 'buy the bottom'.

The second one is the fact that the bears have apparently capitulated. Yes, you have read correctly – it is the bears, not the bulls, that are doing most of the the capitulating. Consider the updated version of two charts i showed in the 'quo vadis' post a while back, the NYSE short interest ratio deviation and Rydex bear fund cash flows. By the looks of these charts, bears continue to abandon their positions, no doubt chastened by the huge one day wonder rallies that have recently, in illiquid banana republic market fashion , heralded at least two false dawns.

the NYSE short interest ratio deviation– it continues to hover at what is at least a 10 year low, deeply in bearish territory - click on chart for bigger image

the cumulative Rydex bear fund cash flow ratio remains at a multi-year low - click on chart for bigger image

In addition to the above, the net short exposure of CTA's , who are highly flexible traders, is now no larger than in November 2000. This is very little compared to some of the short exposures held by this same group during the bulk of the 2000-2002 bear market.

In this context , consider also the fact that most of the trading volume in stocks continues to occur during those times when stocks go up. Bob Prechter was the first analyst to point this strange phenomenon out – he asks, not unreasonably, how there can have been capitulation (of the bulls/long holders) when most of the trading volume is expended in chasing stocks higher (this was once again in evidence last Thursday in intraday trading. Volume began to expand as soon as the market streaked higher).

Mortgage Debt

The third problem for the market is a group of indicators that used to be widely followed for a time, but have lately not been mentioned much as other financial catastrophes took center stage.

I am referring to the ABX-HE and CMBX index products administered by Markit . The charts below show a cross section of the situation , presenting indexes on variously rated debt, from AAA to BBB. If you want to see regular updates of these charts, they have been taken from here(historical ABX-HE)and here(historical CMBX). These may be useful links to bookmark.

Keep in mind that ABX-HE are indexes that refer to the price of the underlying debt pools of residential mortgage debt(down is bad, up is good), while CMBX refers to the spreads of the underlying commercial mortgage debt (up is bad, down is good).

ABX-HE indexes of various residential mortgage debt pools, from highest to lowest ratings - click on charts for larger images

CMBX spreads for different ratings, again from highest to lowest - click on charts for larger images

As one can clearly see, these instruments show that extraordinary stress continues in the mortgage debt markets. It is no surprise that AIG's bail-out requirements have recently swollen to $150 billion from the originally envisaged $80 billion – many of the credit default swaps written by AIG reportedly were for CDO's backed by mortgage debt. Presumably many of these CDO's were once double and triple A rated – however, as we can see, even triple A rated mortgage debt pools continue plummeting in value at great speed.

This means that many bank assets will be subject to further write-downs. Even if a lot of garbage paper has been swept under the 'Level 3' rug, this further deterioration in prices and spreads will likely force a renewed wave of asset revaluations. ('Level 3' is an accounting term - it is where financial institutions house securities for which there is no market price input, hence they can not be 'marked to market' but are valued according to models, respectively are marked to 'reasonable stab' as the method was once described by a Citigroup spokesman. Some people have dubbed this also 'marked-to-fantasy').

Consider in this context the truly sorry looking chart picture of the BKX index below. Similar to the broader market, we can also detect a number of recent potentially bullish divergences, but it is the price chart itself that gives one pause. It does not inspire much confidence.

the BKX (Philadelphia Exchange Bank Index)- bullish divergences, but bearish price formation - click on chart for larger image

The same ideas regarding the short term outlook as outlined in 'quo vadis' still apply – the market is still within the recent trading range, and the direction in which it will eventually break is not yet certain. It is this latter point i actually want to make – while numerous divergences at the recent third 'retest low' seem to favor a rising market, there are still indications that the underlying stresses in the financial system continue to mount.

The Federal Reserve and other central banks have momentarily stemmed the increase in LIBOR with unlimited dollar swap agreements and revived commercial paper issuance by buying CP directly – but this particular hole in the dike - the plummeting value of mortgage backed securities - continues to grow. Arguably this remains one of the most important things to watch, as the ABX-HE indexes have often reliably led the stock market, and also due to the fact that at the height of the real estate/mortgage credit bubble insanity, a full 63% of all bank assets were tied to real estate financing.

One must therefore continue to keep an open mind regarding near term market direction. It is always possible that the bears who have covered their short bets are 'smart' and will get a better opportunity to re-short, and the oversold ABX-HE indexes may well soon bounce. However, there is considerable uncertainty given these data points, and the market lows of 2002 still beckon.

PS: A few words on the G 20 meeting

The recent G 20 pow-wow can hardly be expected to be a panacea for the ongoing crisis. This is merely a bunch of politicians getting together to 'fix' the economy and markets after all – expectations should be muted accordingly.

From what one hears so far, they are actually busy reinforcing the recent deflationary trend in the credit markets, by proposing – what else – 'more controls and regulations'. As i overheard in a German TV newscast, this control is supposed to encompass credit creation (a.k.a. 'credit dirigisme', as now practiced by Uncle Sam with Fannie and Freddie – the state will decide who is 'worthy' of getting credit and who isn't).
The press meanwhile is dishing out the usual pablum about this meeting representing a confrontation between 'US laissez faire' and 'European regulation' principles. Time Magazine lets loose with gems such as 'To optimists, the mere fact that Sarkozy convinced regulation-wary U.S. President George W. Bush to host and attend such a summit was cause for hope.'
There will be some generalizations about every government feeling free to implement a raft of Keynesian inflationary measures intended to counter the financial and economic contraction (expansion of fiscal deficits and even more interest rate cuts), and of course we are promised - more meetings! This is not surprising, as these get-togethers apparently are marked by lavish banqueting. As a warning sign to all supporters of the free market, 'French top officials have applauded the summit results'.
All that has so far been decided falls roughly under the header of 'how can we make sure of making things worse in the long run' - with the sole exception of a pledge to avoid a return to protectionism. The real reason for the crisis was - as was to be expected – not even mentioned in passing as far as i can tell.

Not a single word about the central banks' money price fixing scheme, or the proliferation of regulations and subsidies that has marked the growth of the post WW2 State everywhere – the colossal failure of the state's economic planning was not deemed worthy of debate. Anyone looking toward a government-mandated crisis solution will eventually find out that the interventionist dogma is at the end of its tether – as i have previously mentioned , the economy's pool of real funding is the limiting factor in all state-led inflationary schemes, and it appears that it is in grave trouble globally.

charts courtesy of marketgauge, stockcharts.com, decisionpoint and markit

General Motors and the pending car industry bail-out

noreply@blogger.com (pater tenebrarum) — Sun, 16 Nov 2008 22:33:00 +0000

The icon of US industry , General Motors, is on its death bed. After decades of mismanagement the company has finally arrived at the point where most of its cash resources seem close to exhaustion. Its bonds trade at vast discounts to their face value, and credit default swap spreads on its debt have soared. Its stock trades at levels last seen over 60 years ago, in the early 1940's, leaving the company with a minuscule $1,5 billion market capitalization (approximately). Clearly, in the financial market's estimation , the firm is only one small step away from bankruptcy.

GM 1970 - 2008 - click on chart for bigger image.

As GM itself informs us in a little propaganda brief on its web site, allowing this behemoth to fail – i.e. letting the failure that would surely be its fate in a capitalistic free market economy happen - would have the most dire economic consequences.

Breathlessly we are informed that '5,5 million jobs would be lost – 3 million in the first year, and 2,5 million in the following year'. Furthermore, 'personal income would drop by $150, 7 billion in the first year' , the 'total cost to states and municipalities would add up to $156 billion over three years' (in lost tax income, and unemployment and health care assistance).
Lastly the horror show concludes with 'domestic automobile production will more than likely fall to zero , even for international producers, due to supplier bankruptcies'.

This gathering of vast economic threats is ironically entitled 'GM Facts and Fiction, GM tells it like it is'. The above of course is meant to convey the facts, but rest assured, it is actually fiction (more on that below). GM helpfully provides links for readers of this apocalyptic tale that enable them to let 'US senators and representatives know' how important it is to throw a wagon load of tax payer money into GM's voracious maw ('let's throw good money after bad, we have no other choice').

Presumably this should be done so that GM's clearly incompetent managers can continue to merrily mismanage the company and make further losses over and above those already incurred. This is in fact what GM itself is admitting – even if it gets more funding from hapless tax cows, it will keep making losses for the foreseeable future.

So you're worried about your tax dollars being abused to keep this monstrous case of malinvested capital on artificial life support? Don't fret – 'get out the word to your friends and family and tell them how they can be a part of history too' (via badgering the politicos for hand-outs to GM). They will basically steal your hard-earned dough, but what's that compared to becoming a 'part of history'?

Unfortunately for all of us, it isn't even necessary for citizens to badger anyone. The lobbyists for the car makers, including the powerful United Autoworkers Union (which incidentally bears a great deal of responsibility for the firm's distress , as it has had a considerable hand in saddling it with the legacy costs that have contributed to its downfall) , have already seen to it that the government-in-waiting sees the light.

As Bloomberg informed us last week:

'President-elect Barack Obama is pushing Congress this year to approve as much as $50 billion to save cash-starved U.S. automakers and appoint a czar or board to oversee the companies '

So the state is supposed to not only hand the car-makers $50 billion, it is also supposed to appoint a 'czar or committee' (Bloomberg), to 'oversee the company's restructuring'. Yes, that's right, a committee of government bureaucrats is apparently just what GM needs to be better managed – though one must of course admit that doing worse than the current crew would be quite difficult, but then again we have seen what has happened at Fannie Mae and Freddie Mac since they have become wards of the state – their losses have promptly ballooned to fresh record highs.
And let's not forget, the UAW's shadow hovers over the proceedings – as Bloomberg notes: 'If the plan were to offer no strong guarantees against layoffs it would likely draw fire from unions.'

Nancy Pelosi, the democratic House Speaker, appears to have heard of GM's dire list of threats as well: 'House Speaker Nancy Pelosi called for congressional action, saying failure by one or more of the big U.S. automakers would have a ``devastating impact'' on the U.S. economy.'

GM itself meanwhile demonstrates generosity: ``We've not being prescriptive in what would be acceptable in terms of the loans,'' said GM spokesman Tony Cervone, who said he's not aware of the government's plans.
Well , let's all be relieved that the beggar isn't planning on being 'prescriptive' about the hand-out coming his way. I'm not sure we can believe it when Mr. Cervone adds he's not aware of the government's plans, since it all seems to follow a by now well-worn script.

What has suddenly induced this bout of auto industry bail-out restlessness in the Obama team? Bloomberg has the answer: ``The auto industry is too big to fail,'' said Nariman Behravesh, chief economist at IHS Global Insight Inc. in Lexington, Massachusetts. ``While the Obama administration can wait until Jan. 20 to address other matters, on this one they need to move quickly.''

and : 'A GM bankruptcy could send the U.S. jobless rate as high as 9.5 percent, up from a 14-year high of 6.5 percent in October, and produce a recession comparable in length to that of 1980-82, according to Behravesh. '
``If it does collapse, it could make the recession deeper and longer,'' he said.

In short, everyone has swallowed the GM line, as presented in its scary 'fact or fiction' pamphlet.

Now, i won't argue with the idea that the US jobless rate could go as high as 9,5%. In fact, i too expect it to do that and it's conceivable that it could go even higher. Regarding the likely length and depth of the recession, it seems likely to me that the bust of 1980-82 will look mild by comparison. The biggest credit and asset bubble of all time has burst. We must expect the fall-out to be dramatic in every respect – as it already is.

However, none of this indicates that there is a dire need to bail out ailing industries. The Behravesh conclusion that ``If it does collapse, it could make the recession deeper and longer,'' has it exactly the wrong way around – the opposite is true. Putting GM on artificial life support is what could – and probably will – make the recession deeper and longer. It simply makes no sense to support malinvested capital.

We once again have to consider that in order to support GM and other failing companies, capital must be taken away from somewhere else in the economy. There is no getting around economic truths and economic laws. Just as Obama, in spite of his youthful 'can do' aura can not suspend the law of gravity, he can not suspend the laws of economics.

When he says 'we must approve $50 billion' it does not mean that he can just shake a mythical money tree and $50 billion in capital will fall out.
He appears to have discovered the modern-day equivalent of said mythical money tree though, since Bloomberg also informs us that: 'The president-elect also wants the Federal Reserve to extend emergency loans to General Motors, Ford Motor Co. and Chrysler LLC, according to Obama aides who spoke on condition of anonymity.'

However, neither the Fed , nor the government have a hidden pool of capital somewhere. All they can do is redirect existing resources from where they are now employed to where they think they should be employed.
This is the very definition of a command economy. Instead of the free market deciding on allocation of resources and the employment of scarce capital, bureaucrats are now making these decisions. If this were the proper and most efficient way to allocate resources, we should do away with the 'capitalism' charade altogether and install a communistic system. And yet, even Messrs. Behravesh and Obama and all his advisors would probably agree that this would not be a good idea. They only seem to believe we need to have a 'little bit' of socialism, as opposed to the whole hog version.

If you want to know why, in practical terms, a GM bankruptcy would likely boost the economy rather than harm it, read the following article by John Tamny: 'Pulling Plug On GM Would Help Both Auto Industry And Michigan' (highly recommended).
Mr. Tamny correctly argues that the ineptitude of GM's management has likely harmed Michigan's economy , as capital flees the state as a result.
Meanwhile the dire predictions made by GM and others are simply untrue, as GM's assets would not disappear if the firm were to go bankrupt. On the contrary,since it is to be expected that said assets would be taken over by more capable competitors, this would finally, after decades of ineptness and mismanagement, create an opportunity to see these assets managed in a profitable and responsible manner. There would at last be a light at the end of the tunnel for Michigan's economy.

Not every car maker is running to government demanding hand-outs; this is the exclusive province of those who have mismanaged their assets in both good and bad times.
Nevertheless, all auto makers are now experiencing varying degrees of trouble. Without a doubt the sector's capacities are too large for both present and future consumer demand, and the industry is now forced to 'rightsize' both its production facilities and its car models (sales of gas-guzzlers are for instance unlikely to flourish).
It makes absolutely no sense to attempt to interfere with this process, as it is economically necessary.

For many years, an artificial credit expansion has misled car manufacturers about the expected state of consumer demand – future demand was, so to speak, pulled into the present, as too low administered interest rates sparked a credit and asset bubble, which created what the late Dr. Richebächer has so aptly dubbed 'phantom wealth'.

Nowhere has the 'phantom wealth' concept been more decisively demonstrated than in the just collapsed real estate/housing bubble. When the same houses suddenly cost 15 or 20% more nationwide within a year's time (which is to say, no special reasons for a localized increase in house values could be detected; for instance, if your neighbor were to suddenly strike oil in his garden, your house and land may conceivably become worth more for a good reason) , it does not mean that we all have become 20% richer without effort. It means a credit bubble is afoot, and we are subject to a collective inflationary illusion.

As a little aside, many supply-side economists fell prey to this illusion while it played out. For instance, the prominent supply-side spokesman Larry Kudlow often argued that the huge debt incurred by consumers and their extremely low savings rate were nothing to worry about - after all, so he held, 'wealth had increased even more', due to rising house and share prices. 'Family net wealth, the nation’s true savings rate, advanced 8 percent in 2005 to a record level of $52 trillion.' he averred as recently as 2006 in this article ( which inter alia is marred by the contradiction of his professed belief in a 'capitalist free market economy' combined with the apparently equally deeply held belief that the supply of money and credit should be centrally planned by the Federal Reserve).
Unfortunately, much of it was Richebächerian 'phantom wealth'. When asset prices increase due to monetary inflation, society as a whole does not gain in wealth – it actually loses real wealth, due to a misdirection of resources.

The auto industry is now forced to adapt to reality – as opposed to the previous illusion of prosperity. Hopefully we can all agree that if consumers for instance now demand 12 million new cars per year, it would not make much sense to produce 16 million cars. As an extension to this thought, if consumers prefer cars mad by Nissan and VW over those made by GM, we have to live with that fact as well. This makes the demands of the UAW wholly unrealistic. A decline in employment in the auto sector is unavoidable, whether or not GM and Ford get bailed out by tax payer money. The only question at hand is whether we should allow the market to decide who is best able to deploy the auto industry's capital, or whether this decision should be made by government fiat.
Keeping bad stewards of scarce capital in their jobs only makes life more difficult for those who have been prudent. By bailing out ailing firms like GM, additional damage is inflicted on all its competitors, and once again, avoiding short term pain will likely lead to far greater pain the long term.

PS: the reasons officially given for the pending GM/Ford bail-out omit an important facet to this story: GM is the by far largest issuer of junk rated debt, and the notional value of CDS written on its debt reportedly exceeds the size of the debt by a factor of 10. Even if one were to make very conservative assumptions about the net amount of cash needing to change hands should GM go bankrupt, one arrives at rather scary numbers. The Lehman and the Icelandic bank CDS auctions would look puny by comparison. The specter of cascading cross-defaults is always looming on such occasions, since not all parties to these transactions may hold sufficient reserves against them. This could therefore potentially turn into yet another financial system nightmare. Without a doubt, this is on the minds of policy makers too and an important motivating factor in the bail-out efforts. A tangled web has been weaved by nearly four decades of unfettered inflation of money and credit, and there seems to be no good way of disentangling it.

Should we return to the gold standard?

noreply@blogger.com (pater tenebrarum) — Mon, 10 Nov 2008 14:01:00 +0000

We are living in what one could no doubt dub 'interesting times' ('May you live in interesting times' is a famous curse ascribed to the Chinese, although its origins are disputed). Our entire financial system is under siege – many eminent banks and broker-dealers , some of which survived even the Great Depression of the 1930's have either gone bankrupt or have barely escaped this ignominious fate by being taken over by stronger rivals (often at the 'suggestion' of officialdom).

Governments all over the world have taken steps to not only guarantee all bank deposits (a guarantee which probably only 'works' as long as no-one calls on its fulfillment), but have also force-fed 'capital' to not-yet bankrupt banking institutions in a bid to avert a total seizure of the credit system.
In the meantime, the crisis has begun to engulf entire countries – Iceland, Hungary, the Ukraine, Pakistan, Argentina (once again) are in various stages of extreme financial and currency distress, with some of them having been pulled back from the brink by emergency loans from the IMF (or in Hungary's case both IMF and ECB), and at least one apparently having entered a state of national bankruptcy already (Iceland).

As previously chronicled, there has been a tendency in the press to blame the free market for the calamity – in a sort of 'we had too much of it' manner. These days we are even treated to the spectacle of 'eminent Marxist historians' being released from their crypts and asked for their considered opinions.

However, one also notices that lately some have begun to question central bank policies – specifically those during the Greenspan era. Once upon a time the 'maestro' could do no wrong – congressmen even found it funny that they usually couldn't understand what he was saying (who once remarked: "I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said."). He himself once opined that the central bank under his guidance had 'managed to emulate a gold standard' , when questioned by Ron Paul regarding the apparent evolution in the beliefs he once held.

Naturally, one might ask: if the central bank's goal is to emulate a gold standard, why not just have a gold standard instead? Should we not, instead of leaving decisions about interest rates and the supply of money to a gaggle of bureaucrats , rather trust the historically well established monetary discipline of gold?

Actually, it is the wrong question to ask. It should be reformulated thusly: should money be regulated and administered by the State, or should it be left to the free market?

How much money is enough?

If one looks at modern monetary theories, some things immediately stand out: it is implicitly assumed that the central bank-led, state controlled money system is somehow 'inevitable', and that the money supply should always grow, just not by 'too much' (it is held that there are various ways of achieving this, like e.g. the 'gold price rule' favored by monetarists , which is criticized here).

Most people complain about inflation (this is to say, they complain about rising prices, one of the effects of inflation), but they regard it as a necessary evil that can't be helped – as if it were a sort of permanent natural disaster. As i have explained in my essay about fiat money on Mike Shedlock's blog, there is a reason why fiat money is seemingly workable at all, and there are political – not economic – reasons for why it exists.
It is important to realize that money is not a creature of the state. It did not come into being by state fiat, it has come into being via market processes. Historically, a commodity has been chosen as money, and such a commodity had to have a pre-existing demand, i.e. it had to be useful by itself – otherwise there would be no reason to accept it in payment.
The medium of exchange, which is money's primary role, is the foundation of the modern market economy, enabling the division of labor and a roundabout, complex production structure, something that would be nigh impossible in a barter system.

Often people assume that the money supply must grow, because otherwise, there would simply not be 'enough money' for all the goods and services that are produced in increasing abundance.

To this Ludwig von Mises said: ' No increase in the welfare of the members of a society can result from the availability of an additional quantity of money' (Theory of money and credit, p.102) and 'The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do. ' (Human Action, p.418,421),

Many people would probably consider these to be extraordinary claims at first glance. Consider though what money is supposed to do: its function is to facilitate exchange. From this flows its secondary function as a 'store of value'.
If for instance a producer of perishable consumer goods wants to save, money facilitates this act of saving for him. No-one holds money for its own sake – it is held for the function it promises to fulfill - namely to make the exchange of goods and services possible.
Let us now in this light look at the idea that an increase in the quantity of money confers no social benefit on society as a whole. Assume that for instance, the Federal Reserve were to credit every one of us overnight with an amount of money equal to the amount we already possess – effectively doubling the money supply. Would we be richer than before? Not if the supply of goods and services had not also magically doubled overnight. It stands to reason that such an act by the Fed would almost immediately simply lead to a doubling of prices, given that the supply of goods and services would stay the same and everybody would soon be aware of the doubling of the money supply. This is of course only a hypothetical thought experiment intended to show that it is not the quantity of money that determines our wealth – wealth consists instead of the amount of real capital and real goods and services available.
The workings of inflation are a bit more complicated – and a lot more damaging - than suggested by this thought experiment.

With regards to the first statement – that the total amount of money in the economy at all times is sufficient to secure for everybody all that money does and can do – let us consider a hypothetical free market in which gold is used as money.
It should be clear that like any other good, the money commodity is subject to the laws of supply and demand as well. Thus the money supply would not be entirely stable in a free market either, and both the value and the supply of money would respond to market-based changes in the demand for money.
It is probably safe to assume that a gold-based money supply would only change slowly overall. What then, if the demand for money were to rise, removing some money from circulation? The market response would be two-fold: the value of the money unit would rise, and gold mines would thereby be induced to produce more gold to satisfy the higher demand. The existing stock of money would continue to be able to fulfill its function of securing the services expected of it – after all, what people care about is not the number of gold ounces (or money units, generically) they possess, but what those ounces or money units can actually buy.

We can conclude that Mises was correct – in a free market dispensation there could never be 'not enough' or 'too much' money – the market itself would regulate the supply of money and money's value though market based supply and demand processes.

As an aside, one of the reasons why we know that the market still regards gold as money, even in our modern , legal tender fiat money world, is that exactly the same thing happens nowadays during periods of increased monetary demand. Take for instance the current economic bust, which is characterized by a sharp rise in the demand for money due to increasing uncertainty about the future and the need to repay debt.
One of the things that has happened is that while gold's nominal price has corrected from previous highs, its real price – as measured by the amount of non-gold commodities gold can buy – has risen sharply. This increase in gold's purchasing power is raising the profit margins of gold mines, giving them an incentive to increase production.
How can we explain that gold still acts as if it were money, even though it is not used anymore as an officially sanctioned medium of exchange?
Presumably this is because the market regards gold as the 'money of last resort' – the pinnacle of the inverted monetary pyramid, that would revert to becoming the money supply if the fiat money system were to falter.

gold versus commodities - gold's purchasing power has increased. click on chart for larger image.

The problems of the centrally planned money system

It is odd that modern-day economists seem to be largely of one mind when it comes to the benefits imparted by the capitalistic free market system – for instance, there is almost universal agreement that it is a bad idea for the government to run any kind of business – but they all stop short of extending that thought to money itself. Somehow they seem to believe that bureaucrats are more capable of managing money than the free market would be. For a mainstream economist to suggest otherwise is almost akin to farting in church – it is a taboo subject.

If one wants to understand why this is so, one must consider the reason for the establishment of a fiat money system. As mentioned above, the reason is political, not economic. It is the fiat money system that allows the almost unchecked growth of the state, by enabling it to borrow money into existence that it would otherwise have to garner by taxation alone. Inflation of the money supply is a tax that is not declared as such, and it is a way of redistributing wealth – after all, inflation of the money supply is not instantaneously transmitted to everyone by increasing everybody's money by the same percentage at once as in our thought experiment above, but there are 'first receivers' of the new money being created, which enables them to bid for resources before the rest of the world realizes that money has been diluted. They therefore enjoy an advantage insofar as they can buy goods and services before their prices rise. In short, the fiat money system is one of the ways in which favored groups within society can be bought off, at no cost to those in control of the money system (the economic cost for society as a whole is however grave).

In theory, the establishment of a nominally 'independent' central bank is designed to keep money supply growth in check – as the central bank is usually mandated to 'ensure price stability'. As we will see, this mandate makes no sense – it can not keep the central bank from inducing boom-bust cycles, in fact, it likely makes them more severe.

Whatever one may think of Ben Bernanke's economic theories, specifically his view of the depression era ( i believe he has come to the wrong conclusions about that episode), he has been trying up until recently to run a not-too-inflationary, relatively tight policy. For instance, the various special financing facilities by which he has transformed the Fed into a warehouse for suddenly illiquid bank assets of questionable value, have originally been put in place in such a way as to not increase the supply of money – the Fed simply exchanged one type of securities (t-notes and bonds) for another type (mortgage backed garbage).

In fact, both Ben Bernanke and probably even more so Jean-Claude Trichet who heads the ECB can be considered to be well-meaning civil servants who are taking their mandates seriously.
The problem is that the fractionally reserved banking system as such is geared toward inflation of money and credit. The moment a commercial bank extends a new loan, new money is created when the proceeds of the loan are deposited into the account of the borrower, a deposit that can then be used by the bank receiving it as the basis of a new loan, and so forth. Over the many decades this system has been in operation, an incredible amount of financial claims – and money - have been created.

Another problem is that no matter how well-informed the monetary bureaucrats are about the going-ons in the economy, and no matter how well they think they have adapted their methodologies to the needs of same (there have been various approaches adopted over time, from money supply targeting to interest rate targeting), their decisions regarding e.g. what interest rate to set, must perforce be inferior to a market-based outcome. Since there is political pressure to keep interest rates as low as possible (i.e. as low as they can be without raising the 'inflationary expectations' of the public at large) , there will be a tendency to undershoot the natural interest rate most of the time.

In short, the system will tend to inflate the supply of money and credit. Let us now consider why this leads to damaging boom-bust cycles . In a free market, banks would merely be middlemen helping to channel savings from those who have them to those that require credit.
Savings are not 'money' – they are production that has not been consumed. This unconsumed production can be exchanged for money, which obviously is quite practical. The fact remains though that what has been saved is not 'money' per se, but that money is a place-holder for saved production.
Saved production is what sustains the economy's complex structure of production – it is the real subsistence fund. How the subsistence fund works has been explained in detail by Frank Shostak here, using simple, easy to understand examples.

When deposits are expanded by credit created out of thin air, they are not backed by preceding production. In short, there is now money in circulation that is not a placeholder for saved production – but it can still be exchanged for real goods. These 'exchanges of nothing for something' then begin to distort the economy's structure.

The natural interest rate that would prevail in a free market imparts important information to entrepreneurs : it tells them of the state of time preferences and the consequent amount of real savings available to the economy. Time preferences have to do with the basic idea that present goods are more valuable then future goods – an apple available for immediate consumption is more valuable than one available for consumption at some point in the future. When people's time preferences are low, they will save more relative to what they consume, and the larger pool of available savings will lower the natural interest rate. This is a signal to entrepreneurs that they can undertake longer-lasting capital projects, involving the production of higher order goods – the production structure can be lengthened, and more roundabout production processes will come about. Investment will therefore gravitate toward such higher order goods production, while less investment will be available for lower order, i.e. consumer goods production.

This will ultimately make more consumption possible in the future – the growing amount of real savings sustains higher order goods production, which then increases productivity, making more consumer goods at lower prices available in the future. There is however a constant interplay in this allocation of resources along the production structure, whereby changing time preferences, which lower and raise interest rates, tell entrepreneurs whether to produce more capital or more consumer goods. Remember that the amount of consumption goods saved must be sufficient to sustain those involved in higher order goods production for the duration necessary to implement their investment plans.

From the above, we can summarize the problems that a centrally planned fiat money system produces:

1.one of the effects of inflation, namely rising prices , leads to a redistribution of wealth to those who are first receivers of newly created money from those who receive it later. Prices will never rise uniformly, and will do so with a considerable time lag, and it will always be difficult to judge which price rises are a result of inflation and which are merely a market based signal of demand exceeding supply. However, some groups in society will profit from this, while others will pay for it. Those that pay are generally on the lower rungs of the economic hierarchy.

2.another – the even more damaging effect – is the one on economic coordination. Since entrepreneurs get false signals by means of artificially low administered interest rates, they will channel too much investment toward higher order goods production, distorting the production structure. Capital will be malinvested, as the artificially low interest rate implies levels of future demand that can not be sustained by the state of real savings. This will create a boom, but the boom will turn out to be artificial. The boom is really an artifact of capital consumption – this to say, previously accumulated capital will be consumed as artificial economic activities that would not be sustainable in a free market are undertaken on account of too low interest rates and the creation of money and credit 'out of thin air'. These activities bid scarce resources away from where they would be more profitably employed. Eventually, these economic errors will be revealed, either when the central bank tightens policy, or when the pool of real funding becomes so strained that malinvested capital can no longer be sustained no matter what.

The current situation

In recent decades, central banks have adopted interest rate targeting as their favored method of regulating money. This is best described as a price fixing scheme.
One of the goals officially pursued by this policy is 'price stability' – a very amorphous concept, since prices are supposed to fluctuate in a market economy, and a measurement of 'aggregate prices' is not really possible – we only pretend that it is (if you add up the price of a bag of rice, a car and a hair cut , the result will be a nonsensical number).

Still, the declared intent of the policy is to avert both a fall as well as an untoward rise in the mythical 'aggregate price level' – mind you, 'price stability' is not intended to mean that prices should not rise at all, only that the rise should be capped at some arbitrary percentage every year. In other words, the frog is supposed to be boiled slowly (you, dear reader, are the frog).

At times, increases in productivity will be very rapid – this happens usually when new industries and new industrial processes are introduced after a large leap in technological progress has taken place, and when global trade intensifies, making use of comparative advantages , and furthering the division of labor.

This happened e.g. in the 1920's ,when the car, the airplane and the radio changed the economic landscape, in addition to a modernization of factory production processes, and it happened again in the 1980's and 90's with the advent of the PC, the cell phone, the internet, and connected industries.
In both eras, central banks made the mistake to keep their interest rate policy too loose by pursuing 'price stability'.

In reality, the huge increases in productivity helped to mask inflation, as they exerted downward pressure on prices. Had interest rates reflected actual credit demand as well as time preferences during these eras (which were inter alia marked by sharply rising consumption), rates would have been much higher, and prices, instead of being 'stable' would have fallen instead, reflecting the strides made in productivity increases.

However, underneath the 'disinflationary boom' ('disinflation' is a term divorced from the real meaning of inflation and deflation, meant to describe aggregate prices that rise at a continually decelerating rate of change), inflation actually raged, as the money and credit supply literally exploded. Partly this was reflected in asset prices, which rose like never before, and helped support even more credit expansion, as inflated assets could be used as collateral for more credit. While this was going on, everybody was convinced that a virtuous cycle was underway, while in reality, capital was increasingly malinvested on a large scale.

The recent credit and asset boom reached pinnacles at different times in different parts of the globe, with Japan's combined equity and real estate boom the first to flame out in the late 1980's. The reaction of Japan's policy makers to the bursting of the Japanese twin bubbles helped to set off a fresh round of malinvestment elsewhere in the world, as the Japanese authorities began to inflate even more. Interestingly, although the BoJ eventually expanded base money by over 200% and the state went on an unprecedented fiscal deficit spending spree , Japan's commercial banking system was barely able to create more credit inside Japan (at one point, bank credit contracted for 60 months running). It was clear from this, and from the stock market's inability to re-inflate in spite of the lowest interest rates in the world, that Japan's pool of real funding had suffered enormous damage during the boom.

Japanese monetary data, chart via Bruce Carman. Note how a large increase in Japan's monetary base via so-called 'quantitative easing' failed to increase the broader M2 measure or have any appreciable effect on economic activity (click on chart for larger image).

Next was the technology boom that flamed out a decade later, with stock prices in the Western world reaching unheard of levels and price/earnings multiples. Similar to Japan's situation a decade earlier, rationalizations for this phenomenon were plenty, but the truth was of course that inflation of money and credit drove asset prices to the stratosphere, just as had happened in Japan.
When this boom faltered, it soon became clear that the US pool of real funding had to be in trouble as well, as stock prices continued to precipitously decline in spite of the largest and fastest reduction in US and European interest rates ever.

This decision by the authorities to fight the bust of the inflationary boom with even more inflation managed to create a third boom phase, this time centered on real estate, commodities and emerging market economies. Given the extremely low US savings rate and the fact that the US current account deficit led to a sharp rise in the foreign exchange reserves of surplus countries (mostly in emerging market economies), and the often cited statistic that 'the US needs 80% of the world's savings to finance its current account' we can reasonably assume that this global third boom phase managed to deplete, resp. severely damage, the pool of real funding of the rest of the world as well. In other words, an inflationary expansion in money and credit has led to global capital consumption and malinvestment on a likely unprecedented scale.

Since we can not measure the state of the subsistence fund directly, we have to draw inferences from what happens when monetary and fiscal pumping is employed to counter the ongoing bust.
So far, the outcome is very sobering. Central banks have given up on the idea that they should not inflate, and are pumping all out – interest rates have been slashed to the bone, and various monetary measures under the central banks control are soaring. Governments have either already spent or pledged enormous amounts to turn the faltering economic and financial ship around. In spite , or maybe because of all these interventions, stock and commodity markets have crashed globally.

the US monetary base, 1918 to present, via Bruce Carman. the current amount of monetary pumping is unprecedented. click on chart for larger image

the current composition and growth of the asset side of the Federal Reserve's balance sheet. note that the US dollar is what the Fed's liabilities consist of. the dollar is beginning to resemble the French revolutionary assignat by now (the assignat was 'backed' by confiscated church property, the dollar is increasingle 'backed' by mortgage debt securities). click on chart for larger image.

The chances for re-igniting the boom must be regarded as slim in light of the above. The markets are signaling that economic activities that do not generate wealth can't be revived by means of monetary pumping, a strong sign that the global subsistence fund is in trouble and in need of rebuilding. The best way of achieving this necessary rebuilding would be to let the market do its work, as painful as that would be in the short to medium term in light of the previous excesses.
The point here is that the disease can not be cured by administering more doses of the poison that created the disease in the first place – easy money.
Should the boom against all odds be re-ignited quickly, it would merely set up an even bigger bust down the road – however, this does not seem probable, since this time we would have to draw on the subsistence fund of Alpha Centauri, or wherever it is the aliens live.

Conclusion

We can therefore give an answer to the reformulated question posed above: should the money system be freed from government control and be returned to a free market dispensation? The answer must clearly be yes.
Note that such a transition would not be painless either, but it would nevertheless help to restore the economy a sound footing very fast. We can not say for certain whether gold would be the basis of a free market money system, but considering the historical record, some sort of metallic standard (perhaps a mixture of various metals) would likely emerge. This would by no means mean the end of a modern financial system – on the contrary, since it e.g. seems unlikely that we would start lugging around gold coins in our digital world (the practical implementation of a return to sound money will be the subject of a future blog).

Under a free market money system, the world would likely enter a period of what some refer to as 'benign deflation' , which is to say, prices would fall over time, reflecting increases in industrial productivity. Everybody would gain in terms of real wealth. The same can not be said from a world in which inflation of money and credit continues to be the preferred, government-imposed policy.

Assignat of the French Revolutionary government click on chart for larger image

the form of money most likely to be used by the free market click on chart for larger image

Quo vadis, stock market?

noreply@blogger.com (pater tenebrarum) — Mon, 03 Nov 2008 06:00:00 +0000

Is the stock market a discounting mechanism?

If one looks back at market history, the idea of the stock market functioning as a discounting mechanism becomes very dubious, especially if one looks at the history of the past 10 years. The truth is, sometimes it is, but most of the time it isn't. Since the Asian/Russian crisis of 1998, the market has behaved as a coincident rather than a leading indicator – at times it even lags developments in the economy.

This has been quite obvious in the 2000-2002 bear market, when the market actually bottomed out well after the economic recession in terms of GDP contraction did (in other words, the market lagged the economy), and it has become glaringly obvious in the course of 2007 – 2008.

Consider for instance, that there was a roughly 500 point one day decline in the DJIA on February 27 of 2007, for which two immediate potential triggers could be identified at the time: one was a sharp overnight decline in China's stock market. This was the 'reason' hyped in the press, and can therefore actually be ruled out as a significant trigger – not least because Wall Street had never before worried about what stocks did in China. The second, more credible trigger event, was a sharp decline in a derivatives index product that most stock market traders had up to this point in time never heard about: the sub-prime indexes of the family of ABX-HE indexes , which are run and managed by Markit. Essentially these indexes represent certain residential mortgage debt pools and are used by banks, hedge funds, broker dealers, etc. to hedge mortgage backed debt , respectively speculate on its value.

The sharp decline in these specific indexes signaled growing distress at those mortgage lenders that had specialized in the sub-prime sector of the mortgage market – firms like New Century Financial , Novastar Financial, Fremont General or Accredited Home lenders, the stocks of which used to be market darlings but had been under some pressure for over a year already (in their case, the market actually did fulfill its discounting role), suffered large additional declines. Indeed, it didn't take long for these firms to go under.

However, the one day 500 point market decline remained a one day wonder. Not only that, the market went on to blatantly ignore the message from the then visibly growing distress signals emanating from anything connected with sub-prime mortgage lending, and went on to furiously bid up all sorts of financial stocks, so that several of the companies that by now have been reduced to a status of bankruptcy, zombie-dom or have been nationalized by the government respectively become subject of 'take-unders' by their former competition, reached either new all time highs in the summer of '07 or came close to reaching all time highs.

As examples, consider the charts of the XBD (broker-dealer index) , FNM (Fannie Mae) and ABK (Ambac). In spite of the by then well-publicized problems besetting anything that was involved with mortgage lending and associated derivatives, these stocks traded at very high levels as late as October of 2007.

What accounts for the market's apparent inability to spot even quite obvious economic problems in advance? One can't be entirely certain, but a John Kenneth Galbraith bonmot comes to mind: 'there is (now, was) too much money to invest, and not enough intelligence to guide it'.

The financial industry has grown by leaps and bounds in the just ended era of massive money and credit inflation – and it's a good bet that the amount of 'market intelligence' has not managed to grow at the same rate. To put it bluntly: anyone who was involved in bidding up FNM to almost $70 in October of 2007 was completely asleep at the wheel, and has probably been weeded out by now.

Be that as it may, the fact remains: one can not count on the stock market to 'discount' anything in advance.

(click on charts for larger images)

The Value Trap

The recent sharp decline in the stock market – which not surprisingly, has happened coincidentally with a sharp deterioration in all sorts of economic backdrop data – is best viewed as the 'point of recognition'. Finally, denial about the economy's prospects and the likely extent of financial and economic damage inflicted by the collapse of the biggest credit bubble in history has given way to a collective recognition that the stock market can not be expected to levitate through the ongoing disaster. Elliott wave practitioners are basically of one mind that the crash was a wave 3 down at several degrees - which in E-wave parlance is known as the 'recognition wave' – i.e. the moment when most market participants realize what the direction of the new trend actually is.

As mentioned in the brief report on the gold sector, due to forced deleveraging, many stocks have apparently become quite undervalued now. Several well respected value investors, such as Mr. Buffett (see here) or Mr. Hussman (see here) have advanced arguments to the effect that the panic has created a buying opportunity, irrespective of any further short term damage that might occur. It is certainly correct that risk is now smaller than it used to be; this is obviously a truism, since stocks have become much cheaper.

However, i strongly suspect that a problem with market psychology that i have remarked upon previously in conversations on e-mail lists and fora is still at work here: there has been, and continues to be, a general tendency to underestimate the current bust, both in terms of its likely duration and its likely extent.

Consequently, given the market's consistent failure to do any 'discounting', one should probably be very careful when evaluating this current 'buying opportunity'.
One thing one must keep in mind is that p/e ratios travel in secular cycles. They tend to move from extreme undervaluation to extreme overvaluation and back again, over fairly extended periods of time (20-30 years in each direction, sometimes even longer).

I still remember vividly how the extremely high p/e ratios in Japan's stock market anno 1989 were considered an 'exception to the rule', with countless rationalizations forwarded as to their likely imperviousness. These included assertions such as 'Japan's institutions must invest in stocks' (the 'wall of money' argument) , or 'shares in Japan are never really sold, they are merely passed around between long term holders' (the 'keiretsu' system of extensive cross-shareholdings was supposed to keep share prices aloft), or 'Japan possesses a superior economic model' (the interventionist Ministry of Trade and Industry was actually seen as a positive influence on Japan's economy), and so forth.
Unfortunately for those who believed all this, the Nikkei has fallen to a 30 year low this year, with its average trailing p/e ratio threatening to break below 10.
'Below 10' is actually precisely where p/e ratios tend to fall in secular bear market periods, historically. This puts the current trailing valuation of the S&P 500 Index into perspective – after all, the average decline in GAAP corporate earnings reported so far in the current earnings reporting cycle has been 40% year-on-year.

Lessons Learned?

Let me briefly return to the nature of the current bust. Many, if not most, market observers have for quite some time – in my opinion wrongly - believed that this bust is comparable to previous post World War 2 era busts. Often one has heard arguments to the effect of 'we have seen all of this before' , comparing the situation to what happened e.g. during the 1998 Russian/LTCM crisis, the late 80's/early 90's S&L crisis, the 1987 stock market crash, and recently, more pertinently, but still missing the mark, the mid 1970's bear market and recession.

Lately, comparisons to the experiences made in the 1930's depression have been voiced more often, but are far from having entered into the mainstream consensus. The consensus with regards to this type of comparison is that 'we have learned from the mistakes made in the 1930's, and they will not be repeated'. The current Fed chairman Mr. Bernanke specifically is thought of as a pre-eminent scholar of the 1930's depression, and therefore deemed to be uniquely qualified to avert a similar calamity. One should however realize that people believed the very same thing when the 1930's depression started. Back then, it was believed that the still relatively young Federal Reserve, with its modern 'flexible' currency system would not repeat the mistakes made in the bust and depression of 1873 to 1894. As an aside, in 1873 it was strongly believed that the powers of intervention then in the hands of the secretary of the treasury would surely avert any bad economic outcomes from following on the heels of the 1873 financial panic. Surely the mistakes made in the 1830's would be avoided. Every era shares this belief: namely, that the interventionist wizards at the top will somehow pull a rabbit out of their hat.

Apart from the fact that consensus thinking is apt to be wrong a priori, one can state with reasonable certainty that whatever lessons have allegedly been learned have actually been the wrong ones. While some of the mistakes that have been made in the 30's will likely not be repeated, new mistakes will be made in their stead, and the one, crucial mistake, is being repeated already. Readers of this blog know of course what i am referring to: the idea that fiscal and monetary interventions can avert the bust – this idea is as wrong as it can possibly be. Not only will they not avert the bust, they will make it worse.

Let's briefly look at the major differences between the 1930's situation and today. We know already what the similarities are: in both cases, a giant credit and asset bubble led to malinvestment of capital and capital consumption on a vast scale, laying the foundation for an enormous bust. In both cases, the government felt called upon to intervene in the economy and markets on an unprecedented scale in order to ward off the bust.

The differences are less obvious, so let me try and briefly summarize them: Today, we have 'more furniture to burn to heat the house'. Imagine the economic downturn as akin to a harsh winter (indeed, in the Kondratiev Longwave theory, a secular deflationary bust is referred to as the 'winter season'). If you decide to get through the winter by burning the furniture, having two desks to burn is comparatively better than having just one. Of course it would be better to go out and cut wood, store it somewhere dry, and use it for heating purposes. That is however not the path we are taking. The governments of the world have already decided that burning the furniture is what we're going to do.
Since we have more furniture – i.e., accumulated wealth – than we had in the 1930's, we will hold out longer, and it won't get quite as cold.

The second major difference is one of scale and complexity. For instance, we have far more debt relative to economic output than we had in the bad old days. A large amount of this debt is unproductive – it has either been used for consumption, or has been wasted on investment projects that will not generate any wealth, ever (many such projects only appeared to be profitable while the credit expansion was still ongoing). Both the financial system and the production structure of the economy are vastly more complex than they used to be – the global division of labor as well as global economic interdependence are far more advanced.
On the one hand, one can hope that this complex system will prove to be more resilient than its historical predecessors, on the other, it is this very complexity that makes it difficult to judge what the ultimate effects of the credit contraction and the many 'unintended consequences' of officialdom's interventions will be.
The bureaucrats are like the proverbial bulls in a China-shop – everything they do to plug a hole in the dike on one end immediately opens up new holes elsewhere, which then begets new interventions, and so on, in a never ending cause-effect chain reaction.

In terms of market volatility, size and extent of government interventions, the ratio of debt to economic output and the recent speed of economic deterioration, one really is forced to look back to the 1930's to find any remotely comparable events. We can therefore state: the current bust, regardless of the fact that it will most likely not become quite as bad, is at least of the same general degree.

The short term market outlook, considering technicals

It is always difficult to talk about the short term market outlook, especially when the market is in what appears to be a corrective formation. It often feels like a coin toss, so one is forced to resort to 'if...then' formulations. Anything else is a bit disingenuous – one may get a short term call right, but one can never be certain – it is a matter of probabilities.
Generally, this is easier when the market structure is clear, during impulse waves.
However, from a technical perspective, regardless of what system one uses, one must first and foremost consider the main trend. The main trend is the larger undercurrent upon which the smaller ups and downs play out, and it exerts an influence even during the counter-trend moves.

To make a long story short, in spite of the market's severely oversold status, it is just as likely to immediately break lower to for instance retest the 2002 lows as it is to produce a larger corrective rally first. Normally, one would expect a severe price crash to bring forth a sizable corrective rally, and from the point of view of empirical evidence this has to be regarded as the higher probability bet. The biggest problem with this is that almost everyone seems to agree, and the market tends not to reward consensus opinions. On the other hand, a rash of mutual fund redemptions, extremes in the Investors Intelligence bull/bear ratio, a seemingly – so far – successful retest of the early October low, all support the idea that a bigger corrective rally is now, or will soon be underway.

As can be seen on the chart below, prices will give us a decisive 'if – then' answer soon:

(click on chart for larger image)

The retest of the early October low has produced a number of divergences, that theoretically are short term bullish. However, the market is also closing in on a short term layer of resistance, with further resistance levels indicated by the Fibonacci grid in magenta.
So here is the short term 'if-then' proposition: the dotted blue support line must not break – if it does, then the 2002 lows become a likely target area (SPX 770-780 region). An obvious problem with the re-test is that it has come so quickly. Very little time lies between the two lows. This makes the 'double-bottom' weaker than it otherwise would be.
Noteworthy is also the 'flight of the bears' – consider the chart of the NYSE short interest ratio deviation below:

(click on chart,etc.)

A lot of short positions have obviously been covered. This can also be observed in the Rydex bear fund cash flow ratio, which has declined to a multi-year low (Rydex fund cash flows are a useful microcosm of sentiment):

(click on chart for larger image)

In short, the 'the low is in' consensus should be subject to some healthy doubt. The recent rally has been largely marked by short covering, and there will be less short covering buying power from here on out.

However, it is also quite clear that shorting an already severely oversold market is quite risky – if the market overcomes the layer of price resistance as per the chart of the SPX, then a larger retracement rally , likely toward one of the Fibonacci retracement levels (1040 or 1210) can be expected; this will probably happen regardless of whether or not the market makes new lows first.

The long term market outlook and its dependence on inflationary policy

The market's longer term outlook is to my mind a less problematic topic. A secular bear market started in 2000, and as such secular downturns go, it is highly unlikely to only last 8 years. To wit, Japan's secular bear market has made it to the ripe old age of 19 years as of 2008.
As Bob Prechter and others have remarked, in real terms it is as if the intervening inflationary cyclical bull market in the Dow/SPX of 2002-2007 never happened. In terms of gold (i.e., real money), the market just kept going down, and is now down by some 75%. This is to say, if not for a massive credit and money supply expansion having artificially supported nominal prices, we would be at completely different depths of bear market despair now.

To what levels the market will eventually fall in nominal terms is highly dependent on how 'successful' the central banks are with their policy of inflation, or 'reflation' as it is euphemistically called. It seems unlikely that a 'success' similar to the real estate credit bubble that has brought us to this juncture will be achieved – after all, what is there left that can be inflated? However, one must be aware of something very important here: the very real 'threat' of deflation that is now barreling down on the global economy, is first and foremost a political issue.

Similar to inflation, deflation leads to a redistribution of resources (see Huelsmann,pdf) , only it is a redistribution away from those who profited from inflation to those who were prudent, are debt free and in possession of savings – i.e. , the victims of the previous inflationary cycle. As Huelsmann correctly points out, the supply of money is irrelevant in terms of society's overall wealth – any size of money supply can fulfill the necessary functions money needs to fulfill (to put it differently, it matters not how much money is in one's bank account, what matters is what this money can buy).

If you consider who in society profits the most from inflation, and consequently stands to lose the most from deflation, it becomes quite clear that an inflationary policy will be pursued come hell or high water. The entire modern-day welfare-warfare state is crucially dependent on the inflation of money and money substitutes. The state would shrink without it. Also, the current elites would be replaced by new elites in case of a deflationary collapse of the system (these are also points made in Huelsmann's essay). In addition , we note that the debt expansion of recent decades has ensnared a large part of Western society – 'allowing' deflation to run its course unhindered is simply not politically palatable.

Due to the fact that the banking system is now extremely capital deficient and impaired, the traditional credit transmission mechanisms of the fractional reserve banking system are temporarily not working (it does not matter how many times the White House entreats commercial banks to 'start lending' – they won't do it, because they rightly fear that they will only add more future defaults to their tattered asset base).

However, central banks are already adapting their modus operandi to this circumstance, and can be expected to come up with more non-traditional measures as needed. The direct injection of money into the economy via buying of commercial paper at below market rates as currently practiced by the Federal Reserve is one way in which the banking system is bypassed, and we can rest assured that Mr. Bernanke and the Fed's board will come up with many more ideas in attempting to stem deflation as time goes on. It seems most likely that fiat money will be devalued further, i.e., the approximate 97% devaluation of the dollar since the birth of the Federal Reserve is likely to continue.

Could it be that the central banks will be overwhelmed by the sheer speed and scale of the deflationary contraction? At the moment this can actually not be ruled out completely. Remember what i said above about the 'general tendency to underestimate the crisis'. Even though central bankers have presumably more insight into the problems and potential exposures besetting institutions within their regulatory ambit (very likely the CDS market has already cost Heli-Ben a sleepless night or two), they have only very recently awakened fully to what is going on – which is exemplified by the Fed's balance sheet ballooning by well over 100% over the past 5 or 6 weeks alone. In addition, a large part of the financial system is outside of the regulatory ambit of the central banks – what is commonly referred to as the 'shadow banking system' could well develop deleveraging and default dynamics that will be comparatively difficult to contain.

Ironically, the little propagandistic trick that is used to ensure public support of the central bank system – namely that CB's pose as 'inflation fighters' although they exist primarily to pursue a policy of inflation, may be one of the things that has delayed their reaction. Remember, only a few months ago, the lagged effect of a previous tighter policy stance was not yet in full flower – commodity prices continued to soar, specifically the price of crude oil (as an aside, one can only cringe in despair when one hears central bankers declare that rising oil prices are 'exerting inflationary pressures'; a more thorough confusion of cause and effect is difficult to imagine).
So for a while, the central banks were worried that they might be in danger of losing their 'inflation fighter' reputation, and while they acted reactively and very much ad hoc to the ever more deteriorating financial scene, they were reluctant to pump all-out. Consider that reluctance a thing of the past.

The main point of the foregoing is the following: the historical experience with secular bear markets and secular periods of p/e multiple contractions tells us that the stock market will continue to decline quite a bit more in real terms (this is notwithstanding the fact that the secular bear market will be comprised of several cyclical bull and bear markets – it will be a sequence of lower highs and lower lows in real terms); how low the ultimate low will be in nominal terms will however largely depend on how determined and creative the central banks get in their 'reflation' efforts, or whether they will actually be overwhelmed by the deflationary credit contraction that is currently underway.

One thing that seems fairly certain is that the 'buy and hold' method of investing in stocks will remain a losing proposition for years to come. This should eventually lead to a large swing in the 'allocation pendulum' – institutional allocation percentages that have swung toward bigger and bigger portions of funds being allocated to stocks are likely to revert to much smaller stock market allocations, reaching their low point just in time for the next secular bull market's beginning. Note also that the demographic boost that the stock markets of the Western world received via the 'boomers' is turning into a demographic drag - as of now.

A final remark regarding the mutual fund industry: a more stubbornly bullish bunch is nowhere to be found. The mutual fund cash-to-assets ratio recently stood at a historically paltry 4,5% - considering a roughly 45% decline in the S&P 500 Index from the top, this slightly elevated number (the all time low hit in 2007 was just below 4%) can probably largely be ascribed to the decline in asset values. In other words, whatever selling mutual funds have engaged in appears to have been in reaction/anticipation of redemptions, and not out of fear of a declining market. This is in stark contrast to past bear markets, which have unfailingly seen the industry raise its cash on hand to much higher percentages. This is a fount of potential future selling pressure that one needs to keep an eye on.

Errata: in a previous post i mentioned that the Fed's base money expansion in 1929-1932 stood at 98% annualized; this was erroneous, it should have read: 'the total amount of the Fed's monetary expansion between 1929 and 1932 stood at an annualized rate of 98%'.

charts via stockcharts.com, marketgauge.com, decisionpoint.com

Legislating Prosperity

noreply@blogger.com (pater tenebrarum) — Fri, 31 Oct 2008 11:26:00 +0000

Martin Feldstein is currently the president emeritus of NBER (the National Bureau of Economic Research), the body charged with determining that recessions have begun long after everybody knows they have, is the 'George F. Baker' Professor of Economics at Harvard University, was once the chairman of the Council of Economic Advisers in the Reagan era (during which time he reportedly was unhappy with Reagan's huge budget deficits and acquired a reputation of being a 'deficit hawk' - not that it did much good), and has once been mentioned at being in the running for the nowadays prestigious, if thankless, job of Federal Reserve chairman.

In short, he's the quintessential establishment figure, a high ranking courtier economist if you will. A tiny blemish on his career was inflicted by him having been chief of the AIG financial products division, the one which wrote all those CDS at the height of the bubble that brought the firm to ruin and into government 'conservatorship'.
He's also, at present, an 'adviser to the McCain campaign' , so you would think his views on economics have a free market bent. However, you would be wrong.

A recent Washington Post article informs us, that the no doubt influential Feldstein wants to legislate us back to prosperity.

The problem is that regardless of who wins, this advice will probably be heeded.

"Further legislation to deal with the economic crisis should not wait until the new president takes office. Fortunately, the president-elect will be a senator and can propose legislation without waiting to be sworn in as president." avers Feldstein.

In other words, let's not think too much about it, we need to act now.

Then come the proposals that should make anyone who has actually studied the big busts of the past cringe with apprehension.

Proposal number one is to get in front of the market clearing process and fix prices. Feldstein wants the government to do whatever it can to keep house prices from falling.

Feldstein: "But it is important for Congress to go further and stop declining prices from pushing a large portion of the other 37 million homeowners with mortgages into negative equity, which could tempt them to default. The mortgage replacement loan plan that I suggested in June, essentially a congressionally enacted mortgage "firewall" to prevent prices from dropping too far, is one possible way to do that."

One of the problems the housing industry is facing is the enormous oversupply of houses on the market. Recently, existing home sales have actually been improving. According to Calculated Risk, "Sales were higher in September 2008 than in September 2007 - the first time the year-over-year sales have increased since November 2005."

Now why would that be? The answer should be obvious to economists and laymen alike: house prices have finally reached a level where buyers can be enticed to return to the market - there is finally, a small ray of hope for the housing sector of the economy. Feldstein thinks the best thing we can do is to arrest this process via legislation.

Feldstein then continues with the usual Keynes-inspired yammering about 'falling aggregate demand':

"Falling home prices have already reduced homeowner wealth by about $3 trillion; the stock market decline has cut wealth by an additional $8 trillion. This reduced household wealth is causing consumers to cut spending, leading to lower employment, lower incomes and, therefore, further cuts in consumer spending.
Other components of aggregate demand are also falling. The decline in consumer spending will lead to less business investment in plants and equipment. And the recession in Europe and Japan will further reduce our net exports.
With the Fed's benchmark interest rate down to 1 percent, there is no scope for an easier monetary policy to stop the downward spiral in aggregate demand.
Another round of one-time tax rebates won't do the job. The rebates that Congress enacted this spring failed to stimulate consumer spending: More than 80 percent of tax rebate dollars were saved or used to pay down existing debt."

So you see, saving and paying down of existing debt is, in Martin Feldstein's view of the world, a bad thing. A society that has managed to break all previous records in the total credit market debt-to-GDP ratio due to an ill-fatede experiment with 'elastic currency' and massive credit expansion out of thin air should not , according to Feldstein, begin to save and pay down debt, but finding itself in the current hole , should keep digging furiously. That will make things better.

the total credit market debt to GDP ratio (see if you can spot the bubble periods).

Feldstein believes apparently that now that the biggest credit and asset bubble of all time - a bubble that has probably depleted the pool of real funding of the entire planet - has burst, the inevitable bust can be averted by doing the same things that have been done before in similar situations by other governments, only, this time, the result will be different.

He doesn't trust those irresponsible consumers anymore to do the job though, with their recent saving and paying down debt propensity.

Therefore, he continues, rather lamely:

"The only way to prevent a deepening recession will be a temporary program of increased government spending. Previous attempts to use government spending to stimulate an economic recovery, particularly spending on infrastructure, have not been successful because of long legislative lags that delayed the spending until a recovery was well underway. But while past recessions lasted an average of only about 12 months, this downturn is likely to last much longer, providing the scope for successful countercyclical spending."

They didn't build the Hoover Dam fast enough? FDR did not have 'enough time to use government spending to stimulate economic recovery' because the depression was over so quickly?

Feldstein continues: "The president-elect should focus on developing a mechanism for identifying and funding spending initiatives that can occur quickly and that would otherwise not be done. While it would be good if some of the increased spending also contributed to long-term productivity, the key is to stimulate demand."

Spending that 'would otherwise not be done' is of course apt to be a complete waste of scarce resources. That is precisely why it would 'otherwise not be done'.
Let us also consider the constant worries about aggregate demand. Demand as such is never a problem in an economy, unless the unlikely case were to occur that all consumer wants are satisfied completely. In an economic bust, demand does of course decline, as everybody is trying to rebuild savings and the necessary process of the realignment of the capital structure means that jobs are perforce temporarily lost. The best way to revivie demand is to allow prices to fall and to allow this process of restructuring to proceed unhindered. The more government intervenes, whether by price and wage fixing, or taking the resource allocation process out of the market's hands, the bigger the delay in reviving demand will be.
In short, everything that Feldstein proposes is likely to have the opposite effect of that intended. This should not only be clear from the point of view of economic theory (he is an economist, after all), it should also be clear from the historical experience with government interventions during a bust. We do not necessarily have to go back to the 1930's to see that - we only have to look at Japan's post bubble experience.

Feldstein has more ideas: "The increased government spending should include not only money for infrastructure such as bridges and roads but also for a wide range of equipment. Rebuilding some of the military capacity that has been depleted by the wars in Iraq and Afghanistan could be done relatively quickly and should be part of the overall package."

'Increased government spending on infrastructure' was exactly what Japan did, in spades. To this day, Japan's 'bridges to nowhere' are infamous.
It's nice of Feldstein not to forget the military-industrial complex, but let us consider that the Pentagon - which as of 2001 could not account for $2.3 trillion that had been thrown into its voracious maw (it's a good bet this figure has increased in the meantime) , is already a recipient of tax payer largesse unequalled in the world.
As USA Today reports , the 'Pentagon budget hits record in proposed spending bill', and that is of course not counting the two wars it is 'running on the side' - those require extra spending, and lots of it. So Mr. Feeldstein need not have worried about military spending - more of it is definitely on the way.

Nota bene - the likely cost of the two wars: according to a 2007 Congressional Budget Office estimate, both wars could cost up to $2,4 trillion through the next decade.

benefit: so far, zero. the stated war aims (finding and destroying weapons of mass destruction in Iraq, catching/killing Osama bin Laden and his henchmen in Afghanistan) have not been crowned with success. As is usual in such situations, the war aims have been shifted several times, but the point remains that the original justifications for spending this much blood and treasure have long ago turned into dead letters.

The main problem with Feldstein's ideas remains that whatever interventions government undertakes, the resources that it must commandeer to do so are limited. Whenever government builds a bridge to nowhere, this may add to GDP, but it will diminish society's overall wealth.
The resources channeled toward building said bridge, or building new Humvees for the army can not be used anymore for anything else. In short, we are faced with an analogy to Bastiat's 'broken window fallacy' here.

Feldstein seems to firmly believe that unless bureaucrats decide how to best allocate scarce resources, we are doomed. The exact opposite is true - the more of the resource allocation process is taken away from the market by government, the worse the economic situation will become. There is a reason why the Soviet Union did not turn out to be the utopia of riches it was meant to become - central planning of the economy is doomed to failure a priori.

Feldstein concludes: "Although the economy is facing severe challenges, the president-elect can turn the situation around by introducing legislation to deal with the downward spiral in home prices and with the declining level of aggregate demand. It is important that such legislation be enacted as quickly as possible."

No, the president can not turn the situation around by introducing price-fixing legislation. We should all hope (as vain as that hope may be) that such legislation is not only not 'enacted as quickly as possible' but that it is not enacted at all.

Meanwhile, we should commiserate with the Harvard economics students on whom this man has been let loose.

Gold Stocks

noreply@blogger.com (pater tenebrarum) — Mon, 27 Oct 2008 00:43:00 +0000

The recent stock market crash/deleveraging stampede has hit many stocks to the point where they actually represent value, mainly in terms of the replacement value of the assets held by the companies concerned (earnings are declining sharply, so most stocks are not yet cheap in terms of their p/e ratios).
Commodity stocks of all stripes have been hit especially hard - which is not too surprising considering the very large price declines in the commodities they produce, but to some extent the declines can no doubt be attributed to the fact that many hedge funds have held large positions in these stocks, so the need to delever has put additional pressure on the stocks of basic materials producers.

Interestingly, gold stocks have fared especially poorly - which is a bit incongruous insofar as the gold price itself, while certainly weak of late, has held up much better than other commodity prices. In short, gold has been rising relative to other commodities, which is exactly what is supposed to happen in an economic bust. Note that many of those other commodities represent a big chunk of the input cost for gold miners, with energy the most important cost item. The best explanation for the poor performance of gold stocks is probably that the sector has been more strongly affected by the indiscriminate selling that has taken place due to being relatively small and illiquid.

Recently several interesting things have happened, from a technical perspective.
For one thing, the put/call open interest ratio of all optionable gold stocks combined has risen to 0,64 (data by Schaeffer Research). This may not sound like much, but it is actually a 'pessimistic' reading when brought into the context of the readings that have been observed over the past year - only about 23,5% of all readings have been higher.
Furthermore, gold stocks have rarely been as cheap relative to gold as they are now. This is happening while gold mining margins are actually expanding (remember, input costs have been falling faster than the gold price).

The HUI index of unhedged gold stocks has plummeted to an area of support last seen in 2005, when the gold price was at around $450/oz. - note that this area of support was at the time the lower boundary of the HUI's trading range.
A number of mid tier and junior miners have seen their market capitalizations collapse to below the cash on their balance sheets, i.e. the market values their mining assets at zero now. Obviously this is unlikely to be sustained in the long term - it is largely a result of the above mentioned deleveraging process, and will be reversed once that process is finished.

A further remark regarding the fundamental situation - the best performing stocks in this sector going forward should be the 'pure plays' - i.e. producers that do not depend too much on by-product revenues from e.g. copper or other base metals, resp. also silver. Also, companies that are largely operating in countries the currencies of which have recently weakened sharply should enjoy a considerable advantage in terms of profit margin expansion.

Below are several charts illustrating the situation. A number of interesting developments can be observed; the recent decline has produced divergences with RSI, and the ratio of the HUI to the S&P 500 has gone into the opposite direction of the Gold/SPX ratio. Furthermore, the ratio of Gold to the HUI seems extremely stretched and due for a large pullback (i.e., the HUI and other gold stock indices should soon begin to rise relative to gold).

charts with comments (click on charts to see larger versions):

A failure of capitalism?

noreply@blogger.com (pater tenebrarum) — Sun, 26 Oct 2008 02:50:00 +0000

The 'year of the financial flame-out' as Bob Prechter has christened 2008, so far proves to be somewhat depressing for supporters of the free market.
Not only do we read that sales of Karl Marx' tedious tome 'Das Kapital' are lately taking off, we have also been witness to the depressing spectacle of Krugonomics being found worthy of a Nobel Prize (as an aside, we have no problem with Krugman being a 'Bush critic').

The latest event is a huge government summit dedicated to combating the financial crisis - a get-together of statists of all stripes, who, as a German newscast averred, 'want to put the financial system in chains' (this was uttered in an approving tone). So what are the ideas of these worthies? They want to 'stimulate demand and increase regulation', and -surprise - they 'agree that the IMF should play a critical role' in resolving the crisis.
In other words, doomed-to-failure Keynesian policy prescriptions combined with charging a bureaucracy that many had hoped was finally dying of its own accord with overseeing the unfolding debacle are seen as the panacea that will save us. Oh well.

To be sure, there's a silver lining here and there. For instance, the sudden popularity of Marx may not get anywhere.

"There's a younger generation of academics tackling hard questions and looking to Marx for answers," Mr Schuetrumpf said.
But he doubted their perseverance: "I doubt they will read it all the way to the end, because it's really arduous."

Well, thank God Marx is boring as hell; it's still astonishing that anyone, let along an 'academic' would look to Marx for answers. It has been almost 20 years since the murderous communistic system failed, but surely people do remember that this was inter alia the biggest bankruptcy of all time?
Also, it seems that Krugman's Nobel prize 'can quiet some critics, but not all'. Phew.

Unfortunately this isn't sufficient grounds for optimism; the press all over the world has miscast the crisis and beginning economic bust as a 'failure of capitalism and free market ideology' , an idea eagerly embraced by politicians across the ideological spectrum (proving once and for all that support for the free market was never much more than lip service), who of course love nothing more than expanding the power of the state.

The battle cry of the day is 'we need more regulations'. Consider for a moment here that the EU bureaucracy had already produced almost 100,000 pages of regulations by the end of 2002 (i couldn't find an up-to-date count) , a body of law governing commerce so complicated and convoluted that both compliance and enforcement seem nigh impossible. Between 1997 and 2005 alone, 12,000 new laws were introduced. Businesses across the EU have seen an entire additional bureaucratic jungle added to the one they already battled with in their home countries. No wonder Europe isn't exactly known for vigorous economic growth - entrepreneurs are suffocating in red tape to an unprecedented extent (note that many of the regulations produce situations that can only be described as utter madness).

While the US can still point to a somewhat less regulated marketplace, make no mistake, economic freedom has been on the retreat for decades there as well. The most recent boom-bust cycle of course can be squarely attributed to government intervention in the markets, via a Federal Reserve that left interest rates too low for too long, and the government sponsored enterprises which with their access to cheap credit (on account of the formerly implicit, now explicit, government guarantee) were the major engines behind the housing bubble.
So the people who now charge that the crisis is a 'failure of the free market ideology' should perhaps first show where exactly that free market was allegedly operating.

The above mentioned pow-wow of various heads-of-state has studiously neglected to confront the real reason for the crisis: namely the boom that preceded it. How come there was such an unsustainable boom? Did it drop from the sky unbidden?
Not one of the things that should have been discussed have even been mentioned in passing - central banks and their credit and money inflation, too high and onerous taxation, enormous fiscal deficits, the disastrous over-regulation of commerce, trade barriers. Instead the talk centered on - more regulation.
No genuine reform can be expected from these dunderheads; instead they're - unwittingly - paving the way for a depression.

In his 1969 essay 'Economic depressions: their cause and cure' , Murray Rothbard recounts Ludwig von Mises' view on the subject:

"Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom.

Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off, "laissez-faire" policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.

The Misesian prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.

It has today been completely forgotten, even among economists, that the Misesian explanation and analysis of the depression gained great headway precisely during the Great Depression of the 1930s — the very depression that is always held up to advocates of the free market economy as the greatest single and catastrophic failure of laissez-faire capitalism. It was no such thing. 1929 was made inevitable by the vast bank credit expansion throughout the Western world during the 1920s: A policy deliberately adopted by the Western governments, and most importantly by the Federal Reserve System in the United States. It was made possible by the failure of the Western world to return to a genuine gold standard after World War I, and thus allowing more room for inflationary policies by government. Everyone now thinks of President Coolidge as a believer in laissez-faire and an unhampered market economy; he was not, and tragically, nowhere less so than in the field of money and credit. Unfortunately, the sins and errors of the Coolidge intervention were laid to the door of a non-existent free market economy.

If Coolidge made 1929 inevitable, it was President Hoover who prolonged and deepened the depression, transforming it from a typically sharp but swiftly-disappearing depression into a lingering and near-fatal malady, a malady "cured" only by the holocaust of World War II. Hoover, not Franklin Roosevelt, was the founder of the policy of the "New Deal": essentially the massive use of the State to do exactly what Misesian theory would most warn against — to prop up wage rates above their free-market levels, prop up prices, inflate credit, and lend money to shaky business positions. Roosevelt only advanced, to a greater degree, what Hoover had pioneered. The result for the first time in American history, was a nearly perpetual depression and nearly permanent mass unemployment. The Coolidge crisis had become the unprecedentedly prolonged Hoover-Roosevelt depression."

The parallels between what happened in the boom-bust cycle of the 1920s and 1930s and the events of today are eerie. Once again a huge credit inflation has turned inevitably into a giant bust, and once again governments are trying to avert the bust by inflating even more, by massively raising their deficits, by propping up failed enterprises, and suffocating an already over-regulated marketplace with even more regulations. Rest assured that as the bust progresses, their interventions will continue to grow in scope and extent, in a desparate attempt to keep a system alive that is doomed to failure a priori.

The biggest mistake made in post WW2 economic history was to cut all links of the currency system with the vestiges of the gold standard - this removed the only remaining check on the expansion of government debt and the associated expansion of money and credit more generally. It is also seldom discussed that the Federal Reserve removed another important brake of unchecked credit expansion in the mid 90's by allowing banks to use the 'sweep' method to lower their reserve requirements. Since term savings deposits have much lower reserve requirements than demand deposits, banks 'sweep' the unused funds in demand deposits into non-interest bearing CDs, temporarily transforming them into savings deposits. Ever since this became the norm, the banking system has been de facto insolvent (which is to say, it could not possibly survive a run on deposits).

Governments are now injecting huge amounts of money into the banking system, but are faced with the fact that the credit intermediation process has broken down. Neither are banks willing to lend, not are potential borrowers very eager to borrow. Instead, banks are hoarding this money, as they expect even more writedowns to hit what is left of their capital in coming months. This is of course a reasonable expectation, as the corporate default rate has only just begun to tick up, and consumer credit defaults , including mortgage defaults, are likely to continue to climb.

As Frank Shostak explains in his essay 'Good and Bad Credit' , it is really the state of the pool of real funding that determines if monetary pumping can seemingly 'work'.
Money created out of thin air merely dilutes the money already in circulation, it can not create one iota of wealth or real resources. As long as the pool of real funding (explanation of the term can be found here) is still expanding, monetary pumping will divert resources into economic activities that are not really self-funding and create no wealth - an illusory boom ensues (with the recent housing boom representing a pertinent example).

It is important to realize that the pool of real funding is put under pressure by such an artificial credit-induced boom. In other words, there comes a point in time when the pool of real funding is exhausted, and begins to stagnate or shrink - namely once one boom too many has diverted so many resources and led to capital consumption on such a great scale that the 'point of no return' has been reached.
While the subsistence fund is not directly measurable, we can guess when it has begun to stagnate or shrink by observing what happens when the central bank lowers rates and begins with monetary pumping. If there is no effect (most immediately the effect should be visible in financial markets, which tend to discount the future), i.e. the boom fails to be reignited, then we have reached this point.

In short, it will not matter how much money out of thin air is thrown at the banks when real resources are not available in an amount sufficient to allow for the resurrection of bubble-like activities. This brings us back to what Rothbard wrote: once one is in this situation, it is necessary for the structure of production to be realigned with the new reality, and consumed capital needs to be rebuilt.
A bust becomes inevitable - with the consolation being that the bust is the economy's method of achieving these objectives, i.e. it is the economy's way of healing itself, and laying the foundations for renewed growth.

Obviously, any government interference with this process can ipso facto only be harmful. If one thinks things through, it becomes clear that contrary to widespread misconceptions, government does not possess a tree on which resources and capital grow, and it has not bunkered any of these things in a warehouse somewhere either. It can only take resources from someone else and shift them around. It perforce must take them from those sectors of the economy that still produce wealth (the bankrupt entities it tries to bail out are obviously consumers of wealth), in other words, this centrally planned shifting around of resources will weaken those sectors of the economy that are still healthy.
It does not matter in this context whether government crowds out private sector borrowers by borrowing the money used in these wealth transfers or whether it acquires the money by taxation - the effect is the same.

There is of course a third option, which will no doubt play an increasingly important role going forward - government can, vía the central bank, simply print money up. This will be limited by the so-called 'bond vigilantes' putting in an appearance at some point, but in the meantime, is apt to do untold economic harm. The Federal Reserve has in recent weeks roughly doubled the size of its balance sheet, and the growth of high-powered 'base money' over this period stands at a roughly 130% annualized rate.

Students of economic history take note: from 1929 to 1932, the annualized growth of base money was 98% and free bank reserves were increased by over 400%.
This will come as a surprise to those that have heard the false claim (which for reasons unknown gets repeated over and over again) that the 'Fed failed to pump enough money into the economy in the early 1930s'.
The Fed did in fact do what it is doing now - it slashed interest rates to the bone, and pumped furiously. Only, it did not help, as the pool of real funding had suffered too much damage in the 1920's credit boom.

Today, we find ourselves at a very similar juncture - just as leftist propaganda held in the 1930s that 'the free market had failed' , prompting massive government intervention that turned a sharp recession into a depression, so we are today at a point where the same propaganda claim is being made, and governments once again respond by intervening in the market at an unprecedented scale.
To expect a different outcome, is to paraphrase Einstein, 'the very definition of insanity'.

click on chart for larger image

Greenspan is 'shocked'

noreply@blogger.com (pater tenebrarum) — Thu, 23 Oct 2008 18:51:00 +0000

WASHINGTON (Reuters) – Former U.S. Federal Reserve Chairman Alan Greenspan told Congress on Thursday he is "shocked" at the breakdown in U.S. credit markets and said he was "partially" wrong to resist regulation of some securities.

Despite concerns he had in 2005 that risks were being underestimated by investors, "this crisis, however, has turned out to be much broader than anything I could have imagined," Greenspan said in remarks prepared for delivery to the House of Representatives Committee on Oversight and Government Reform.

"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief," said Greenspan, who stepped down from the Fed in 2006.

Banks and other financial institutions need public support, such as the recently approved $700 billion bailout package, to avoid a serious reduction in credit, he said.

This deserves a few comments.

1. Greenspan is 'shocked' about the wrong thing. It is certainly not a lack of regulation that brought about the crisis. If you think about it, the credit market segment that actually blew up first - the mortgage credit market - has been, and remains, one of the most heavily regulated segments of the credit markets. Does anyone actually believe that if otc derivatives markets had been subject to more regulation, then the crisis would not have occurred?

We have seen credit boom heaped upon credit boom, with the attendant malinvestment of capital on a grand scale. It appears likely that capital has been consumed to such an extent that a very severe economic bust will be required to repair the discoordination of the capital structure and liquidate/redirect all this malinvested capital. Indeed, the cartelized banking system played a major role in bringing this state of affairs about, and finds itself at the center of the storm. However, no amount of additional regulation could have possibly averted this outcome.

It's funny, but probably not too surprising, that Greenspan is so eager to throw overboard what little he had in terms of credentials in support of the free market, by 'admitting' that even more regulation would perhaps have helped avert the calamity.
In a free market, the banks would indeed have acted more cautiously, and their self-interest to protect their shareholders equity would have been far more pronounced.

The root of the problem is not with this assumption turning out not to be true - the root of the problem is something else. The banks and broker dealers were subjected to the wrong incentives - by an agency that has nothing to do with the free market. The root of the problem is the monetary system itself - the one that Greenspan helmed - the fractionally reserved fiat money system, at the center of which we find a central economic planning agency - the Federal Reserve.
Greenspan's greatest error was to believe that modern day central banks had somehow managed to 'emulate a gold standard', as he once averred in a q&a with Congressman Ron Paul.

This is manifestly not the case, as the sheer unlimited credit creation during Greenspan's reign (inter alia) attests to.
It is of course obvious by dint of economic theory as well that letting a gaggle of bureaucrats fix interest rates can only lead to economic outcomes that are worse than those a free market set interest rate would lead to.

The bureaucrats manning the Federal Reserve are in exactly the same position that the Soviet GOSPLAN agency found itself in: they can not possibly know what the correct interest rate should be at a given point in time. , just as GOSPLAN never knew how many tractors, how many chickens and how many shoes should be produced.
This is the problem Greenspan should have acknowledged, but that is of course 'impossible' for a former central bank chief, even though i personally suspect that he actually knows better.

2. 'Banks and other financial institutions need public support, such as the recently approved $700 billion bailout package, to avoid a serious reduction in credit, he said'

He would say that, wouldn't he? It wouldn't do to for instance tell the congregation of honorables 'you idiots have just thrown 700 billion of good money after bad and in all likelihood helped to transform a sharp recession into a long-lasting depression', even if it's true.

If the economy's pool of real funding is stagnating or shrinking - and there are good reasons to believe that that is the case - then it won't matter how much money is thrown at the banks - they still won't lend. The propping up of failed enterprises is pretty much the worst thing one can do as it were, as the necessary adjustment process that the economy must go through is hampered and delayed with such interventions. Not only that, but the already problematic situation of the pool of real funding becomes even worse. After all, the government has to take this money from someone else. Who can it take the money from? Obviously, the only providers of capital at this stage must be those in the economy who still produce wealth. Their situation is made worse in other words, while entities that are de facto bankrupt are being put on artificial life support concurrently. Hank Paulson tried to sell these socialistic policies as some kind of 'lesser evil', but they are not - they are both evil and grossly mistaken, period.

In fact, one shouldn't be too surprised that the stock market greeted the bail-out package with a crash. Even though the above facts are seldom spelled out (recommended reading matter in this context can be found at www.mises.org - look specifically for the very lucid explanations provided by Frank Shostak), the market mind is aware of them, on a subconscious level.
Naturally, forced selling via margin calls, redemptions from hedge and mutual funds and so forth, conspired to make a bad situation in the market even worse, but first and foremost the market finally discounted what all the government interventions in the economy will likely produce: a long lasting, and far more severe economic downturn than the one that would have occurred had the government adopted a hands-off policy.

No-one in a position of power has yet stopped to ask why similar interventions by Japan's government resulted in a now 2 decades long slow-motion depression. The common refrain is though that 'they have not intervened enough'.
Well, the way things have been going of late (with e.g. the closet communist Sarkozy from France demanding the 'renationalization of certain important industries'), we may soon end up with everything nationalized. After all, there are e.g. not many corners of the credit markets left that have not been 'backstopped' by some or other central bank or government.
As sad as that would be, there is one bright side to this: no-one would be able to claim anymore that 'they have not intervened enough'. This nonsense would finally lose its cachet once capitalism has been saved by means of utterly destroying it.

Can government avert the crisis?

noreply@blogger.com (pater tenebrarum) — Mon, 20 Oct 2008 12:54:00 +0000

In a word: No!