Tuesday, March 29, 2011

When does a country lose access to the bond markets? Also a post on the value of MMT

Paul Krugman had 2 bizarro blog posts this weekend wherein he had a thought experiment- He took today’s government deficit (something he supports) and extrapolated it indefinitely into the future. Further, he speculated a world, set in 2017, where today’s deficits has resulted in world with full employment, but where government (because of supposed ideology) still NEEDS to incur a deficit, and this is the kicker, where the country has lost access to the bond market. He concludes that the scenario he described – 6% deficit, all money-financed rather than bond-financed, will result in 400% hyperinflation a year.

Crucial to understanding where Krugman is in error is knowing why he thinks the US will loss access to bond markets. Under what circumstance can it lose it, and why losing access is the logical outcome in that scenario.

Krugman: Suppose, now, that we were to find ourselves back in that situation with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.

Here’s his mistake, in a nutshell. Countries that lose access are usually those losing productive capacity, filled with dying industries, its people out of work. Hence, it could not produce the income needed to credibly pay its obligations (foreigners fear that it will either lose tax revenues that it can use to pay back the bond), or it will simply monetize the debt, inflating away the real value of the bond. It is in this scenario that foreign bond investors will only buy at exorbitant rates, to compensate for the bond’s high credit risk, and the calculated depreciation loss due to monetization. Also, in this scenario, where many locals do not have income, they cannot take the place of the disappearing foreign bond investor.

Now if the US ever really gets to a full employment scenario, its locals will have productive income. Some of them will begin to think of the future, and save some of that income. The logical choice would be in the currency that they plan to use in the future. US bonds are the logical choice.

And if there is full employment, we can deduce that the economy is growing, hence there is less risk of the bond payment being monetized and inflated away, or of deflationary measure eroding the productive capacity of the country, and its ability to pay. Hence, foreigners will even more likely see it as a safe haven to invest in.

So how can we see a scenario in 2017 where the US has full employment, but the government still has to incur a deficit, and at the same time has lost access to the bond market?

And yet the same Krugman fully supports the unconventional monetary policy we call QE2. QE2 depreciates the currency, thereby discouraging foreigners from buying US bonds (The future currency loss means they actually incur negative yield from investing in it). QE2 doesn’t improve employment, so it doesn’t increase the number of locals with income who can invest in the missing foreigners’ place.

With QE2, only the Fed ends up the natural buyer of bonds, resulting in even more QE, leading to more depreciation, and even less natural buyers. Even more so, if QE convinces investors that it will cause future inflation, QE results in more would-be buyers shunning it altogether.

So could Krugman’s scenario where the US has lost access to the bond market really be an extrapolation of today’s policy choices, where there’s endless flooding of reserves into the banking system while government’s cutting fiscal spending?

It’s unfortunate that a lot of people (and economists) don’t know what policy choices actually lead to destroying the currency, or restoring aggregate demand, or to stimulating the economy. More often, people who are most vocal about what policy choices to follow that actually atrtibute the cause and effect exactly opposite to how it is.

Krugman wrote the post to illustrate his differences with the MMT crowd. Which is again unfortunate, because I’ve found that MMT descriptions of how the macroeconomy works is the most technically correct , provides a seriously objective framework to understand what actions cause which vs. what, and is the only economic framework that incorporates how credit and investment actually functions and affects the overall economy.

To put it in analogy, MMT looks at a fire and notices that firemen are the most effective method to combat the fire. By comparison, the classical explanators are those who notice that whenever there is a fire, there always seems to be a lot of firemen. So hence, the best way to decrease the number of fires is to decrease the number of firemen.

Previously, if you were in any finance type of work, you could safely ignore macroeconomic prognoses on your industry based on the classical view, and your ignorance of the prognoses would not affect you in any way. Now you ignore macro analyses based on the MMT framework at your peril.

Scott Fulwiller provides a more technical reaction to Krugman here.

Friday, March 25, 2011

Fiscal vs. Monetary policy; a fiscal suggestion

If you’ve been reading for the past 6 months, it should be quite obvious by now that I’m not in favour of monetary easing. To me, belief in its efficacy is like belief in the morality of the gold standard. Together, they just put a collar around the entrepreneurial spirits of the real economy. The gold standard puts a ceiling to the level of real economy demand a free market can achieve on its own, while monetary easing puts a floor to any real adjustments the economy needs to make in order to rejuvenate itself again.

If you’ve been with me some time on this blog, you’d probably notice that my prescription leanings for restoring aggregate demand tend to be on the fiscal side, as long as it’s coupled with capital controls. I would be more open to monetary policy action, as long as its coupled with strong, dynamic macroprudential policies (My belief is that easing can be useful, for as long as there is no concurrent balance sheet recession going on to offset it).

Monetary easing in and by itself is pro-speculator, and anti-poor. And while monetary easing by a default currency issuer may not be hyper-inflationary to the issuer, it is for all others who use that currency. Unmitigated easing only hastens the day that other nations start to refuse it as the default. And if you really think about it, for as long as monetary easing leads to more speculation, which leads to higher prices for commodities, it only results in even less investment in the real economy. So it’s quite the facetious prescription to jumpstart an economy.

The problem with fiscal policy, on the other hand, is that it is so broad-based a prescription, and any one of fiscal policy recommendations can also end up counter-productive or inconsequential to the greater economy. As for me, I would consider myself open to a fiscal policy action that incentivises local companies to start getting more into labour-intensive businesses. This means subsidies for firms that avoid automation and/or outsourcing. And conversely, higher taxation on those who insist.

Obviously this means higher cost of goods locally, as well as the possibility of losing export market share, as local producers need to start using local employees when more cost-efficient ones can be found overseas, or by automation. So this is where the subsidy could come in. The government will buy the goods from the local producer at its cost of production, plus a reasonable return to the producer for his effort ( though nothing for the non-existent risk of finding no market), then the government simply turns around and sells the goods at the global clearing price.

I know what you’re thinking. Protectionism! And this could lead to more global infighting. Well, unfettered globalism has just led to infighting anyway, why not do something to restart local demand while doing it anyway? (sarcasm). Right now, we’ve already got a so-called currency war ongoing, and who knows where this will lead to next.

And if you’re thinking of the endless millions the government will squander buying local goods at cost and selling for a loss, well, it’s probably no different fiscal outcome from building bridges to nowhere, but hopefully local businessmen start getting the message that the government is serious about stoking local demand. Buy local, sell local, hire local. Who else to lead the way than a government currency issuer with no budgetary constraints (other than the fact that doing so can cause real inflation, which would at least be due to real demand being stimulated, rather than stimulating commodity speculation).

I know what you're thinking - this recommendation also undermines free market. But globalization and the hollowing out of local industries has also undermined the free market, in that it has stacked the odds in favour of the very big, whose example everyone has to follow, and the many-tentacled, which ends up controlling everything. Of course, there’s a lot to think about in operationalizing something like this, such as establishing a local quality board that ensures companies that sell to government produce using current global best practices.

I’m not saying that we reverse globalization, but we need to halt it in its tracks for the meantime, before it destroys more locally generated income. And what I’m thinking need not be permanent, but simply to jumpstart demand in currently demand-constrained areas of the world, and then the free market could probably take it from there.

But if after fiscal policy stepping back, automation and outsourcing gets back in vogue in a big way, hello government. If market participants can be cowed into thinking that they should get into risky investments because the government might eat away their returns via monetary easing, they could be cowed into thinking that the government will easily restart taxing anyone who starts hollowing out his company in the next upturn (and support those who don’t).

It’s probably either this—or if we can’t stop globalization in its tracks, we should already start thinking about bringing down national boundaries. Yup, no more nation-states. If capital will be free to go anywhere in the world to chase the highest returns, everybody else and everything else should be too. Otherwise, capital will simply go wherever it pleases, and damn it if turns a few more millions into permanent ‘slumdogs’. But since I don’t see anyone, other than John Lennon, imagining a world with no country, we better start thinking, for the moment, a world with less globalization (and more fiscal policy action to help this along).

Wednesday, March 16, 2011

Will QE2 be reversed in June? If they do, who'll buy the treasuries?

PIMCO seems to think so, and in that regard, they are now fully out of Treasuries. Yes, the world’s biggest bond funs is out of Treasuries in anticipation of the June end of QE2, with the expected increase in government cost of borrowing the end of the program entails. In fact, Bill Gross, PIMCO co-managing director, asks: With Fed responsible for 70% of Treasury purchases (foreigners being the rest), who would buy Treasuries after the Fed stops buying, and starts selling?

My $0.02, QE2 will not be reversed in June. Here are my reasons:

1. QE2 forced investors to take on more risk, to get into stocks, commodities, emerging markets, even synthetics. A reversal of QE2 will certainly lead to CC2 (Credit Crisis 2)

2. Because people/investors are still leveraged (In fact, QE2 encouraged them to further leverage, with its negative interest rates and corresponding rising asset prices). Those who could still borrow bought into assets, and rising rates would lead those over-extended and over-leveraged into, probably, an even worse situation than if there had been no QE2 at all.

3. A reversal of QE2 also means falling asset prices, as people exit out of risk positions. Hence, the Fed will likely have less credibility the next time it undertakes QE3, etc. QE’s effectiveness lies in people’s belief that it will raise asset prices, and hence, their wealth.

4. The Fed is already probably into NGDP targeting, which as we previously discussed, targets a 5% (or more) annual NGDP as a means of stimulating growth. So since RGDP still doesn’t have its own legs, 5% target means more easing is still on the horizon.

The genie is out of the bottle, you can’t just bring it back so easily. In the off chance I am wrong, and the Fed does reverse QE2, well, I see no downside at least for PIMCO. In fact, QE2 may have given them ‘found money’. They sold out of Treasuries when QE2 dropped yield. Why wouldn’t they buy when QE2 reversal jacks yields right back up? To answer PIMCo’s question: Who would buy Treasuries after the Fed stops buying, and starts selling – PIMCO seems like the best candidate.

And if the Fed ends up the losing side? Don’t worry, the Fed is already on it.
Update: Above statement clarified here.

Thursday, March 10, 2011

US banks don't need borrowers in order to 'lend'

Who says that a bank needs to find a willing and creditworthy borrower for it to be able to lend out money? Only incompetent unimaginative putzes will insist that a willing borrower be at the other end of a profitable banking transaction. This is what separates the men from the boys; the masters of the universe form the masters of the basement.

All you ever need, to have a profitable ‘lender’-like arrangement, is a willing credit default insurer. And with the environment the way it is nowadays, willing parties for this arrangement practically fall from the sky. Opportunity abounds to create synthetic junk bonds. Here is a list of some of the things bankers are most thankful for, that make this unbelievable wealthmaking opportunity possible for those willing to go for gold:

The CDS market Where would we all be without this wonderful market? Probably just sitting around all day, staring into the ceiling whilst we drink endless pitchers of kool-aid. Because of the so-called credit default swap market – anyone - regardless whether he’s an actual lender or not, can enter into an insurance protection program with a willing seller of insurance a.k.a. CDS counterparty. Don’t have an existing relationship with some debt-hungry junk debt, oops, sort, high-yield corporate debt issuers you wish you had on your rolodex? No problem, you can still get a potential payout, as if you were a lender, in the event that they go into default, courtesy of the CDS counterparty/insurer you have a payout arrangement with.

Yield-hungry chumps insurers Why would anyone be willing to give a payout to a non-lender in the event of a credit default by a borrower who probably doesn’t know said non-lender from adam? Simple. How much is in it for him? Promise to pay the insurer high enough premiums, and he’ll give you protection from the boogieman himself. After all, it’s not everyday that a big corporate issuer suddenly declares bankruptcy, right? In all likelihood, he’s thinking… since issuer A has never defaulted before, there’s likely a small probability of him ever doing so. Who are you to argue with history?

Fed interest rates Still, why would anyone want to enter into an insurance arrangement where they could end up paying out debt obligations of a defaulting issuer to any ‘JP Morgan wannabe’ in exchange for some premium payments? Well, you’ve got the current low interest rate environment to thank for that. Correction, you’ve got the current negative interest rate environment to thank for that. Large institutional investors are going out of their wits looking for that high yielding instrument that could help them attain those rosy blue sky returns they’ve promised to their retail Joe Schmoe investors, when they were still busy collecting those assets from Joe. Today’s current interest rate environment was designed specifically to push investors to take on more risk. There are never enough high yield debt, so you synthesize it.

US Government Hey, we’ve got history on our side here. What happens when the unthinkable happens, when the underlying issuer defaults and the insurer ends up having to pay out its obligations to Mr. Morgan wannabe? Uncle Sam will come in, of course. After all, when all the Joe Schmoe investors in the chump insurer stands to lose all of their pension and retirement funds because of said insurer’s decision to be the stupidest guy around the table when dealing with more sophisticated parties, you can bet that the Uncle will be thinking of his beloved voters, and of the implications of non-action to the entire financial system.

Why do banks get into derivative swaps? This is practically a no-brainer.

Capital arbitrage Oh, come on. You’re getting credit protection from a known default risk. At the worst case, this has got lead to capital improvement for you somehow. You just have to be crafty. Chuck Norris kick to you, Basel II.

Derivatives holders are actually paid ahead of unsecured creditors. ‘Nuf said.

When you take insurance from a protection seller, you are effectively selling short such underlying security. More short selling puts more stress on the issuer/borrower, by increasing issuer’s cost of borrowing. This leads to greater likelihood that your hoped-for payday comes much sooner. Know what's cooler than a million dollars in CDS payouts? A billion dollars in CDS payouts! Ka-ching!

related post: US banks are not capital-constrained