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The biggest problem facing investors today is that “the rules” of the game change almost every year.
What I mean is that any basic rule investors took for granted could be thrown out the window. Indeed, in the last five years we’ve seen:
1) Accounting standards at financial institutions suspended.
2) Capital requirements for banks (Basel III) postponed multiple times.
3) Fraud go unpunished.
4) Obvious insider trading amongst political officials and banking insiders.
5) Central bankers openly admit that they will lie to investors.
Why are so many laws and rules being thrown out?
The Powers That Be are committed to propping the system up by any means possible.
Spain’s banking system, by any reasonable analysis, is totally bankrupt.
The reason for this is that Spanish banks are all packed to the brim with garbage assets (mortgage loans and Spanish Government bonds… which aren’t worth the paper they’re printed on).
Consider the story of Bankia.
Bankia was formed by merging seven bankrupt regional Spanish banks in 2010.
The new bank was funded by Spain’s Government rescue fund… which received “preference shares” in return for over €4 billion (from taxpayers).
These preference shares were shares that a) yielded 7.75% and b) would get paid before ordinary investors if Bankia failed again. So right away, the Spanish Government was taking taxpayer money to give itself preferential treatment over ordinary investors.
Indeed, those investors who owned shares in the seven banks that merged to form Bankia lost their shirts. They were wiped out and lost everything.
Bankia was then taken public in 2011. Spanish investment bankers convinced the Spanish public that the bank was a fantastic investment. Over 98% of the shares were sold to Spanish investors.
One year later, Bankia was bankrupt again, and required the single largest bailout in Spain’s history: €19 billion. Spain took over the bank and Bankia shares were frozen on the market (meaning you couldn’t sell them if you wanted to).
When the bailout took place, Bankia shareholders were all but wiped out, forced to take huge losses as part of the deal. The vast majority of them were individual investors (the bank currently faces a lawsuit for over 140,000 claims of mis-selling shares).
So that’s two wipeouts in as many years.
The bank was taken public a year a second time later in May 2013. Once again Bankia shares promptly collapsed, losing 80% of their value in a matter of days. And once again, it was ordinary investors who got destroyed.
Indeed, things were so awful that a police officer stabbed a Bankia banker who sold him over €300,000 worth of shares (the banker had convinced him it was a great investment).
Which brings us to today.
Bankia remains completely bankrupt. But its executives and the Spanish Government continue to claim that things are improving and that the bank is on the up and up. Indeed, just a few weeks ago, the Wall Street Journal wrote an article titled “Investors Show Interest in Bankia.”
The story featured a quote from Spain’s Finance Minister that, “… it is logical. The perception of Spain has improved and Banki has improved a lot.”
Bear in mind, this is a bank that has wiped out investors THREE times in the last THREE YEARS. So that’s three different rounds of individual investors being told that Bankia was a great investment and losing everything.
Every single one of these wipeouts was preceded by both bankers and Spanish Government officials claiming that “everything had been fixed” and that Bankia was a success story.
And now the Spanish Government is trying to convince them to line up for a fourth round.
This kind of fraud and lawlessness is unbelievable to me. But it is indeed how the world works today. Those who have power will do anything they can to retain it. This includes, lying, cheating, and stealing.
And while certain items relating to this story are unique, the morals to Bankia’s tale can be broadly applied across the board to the economy/ financial today.
Those morals are:
1) Those in charge of regulating the system will lie, cheat and steal rather than be honest to those who they are meant to protect (individual investors)
2) Any financial problem that surfaces will be dealt with via fraud or lies rather than taking a hit. This will include short selling bans, stocks being frozen, bail-ins, and worse.
3) When the inevitable collapse finally does hit, it will be individual investors and the general public who get screwed.
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There is a lot of confusion about which limit we are reaching with respect to oil supply. There seems to be a huge amount of “reserves,” and oil production seems to be increasing right now, so people can’t imagine that there might be a near term problem. There are at least three different views regarding the nature of the limit:
- Climate Change. There is no limit on oil production within the foreseeable future. Oil prices can be expected to keep rising. With higher prices, alternative fuels and higher cost extraction techniques will become available. The main concern is climate change. The only reason that oil production would drop is because we have found a way to use less oil because of climate change concerns, and choose not to extract oil that seems to be available.
- Limit Based on Geology (“Peak Oil”). In each oil field, production tends to rise for a time and then fall. Therefore, in total, world oil production will most likely begin to fall at some point, because of technological limits on extraction. In fact, this limit seems quite close at hand. High oil prices may play a role as well.
- Oil Prices Don’t Rise High Enough. We need high oil prices to keep oil extraction up, but as we reach diminishing returns with respect to oil extraction, oil prices don’t rise high enough to keep extraction at the required level. If oil prices do rise very high, there are feedback loops that lead to more recession and job layoffs and less “demand for oil” (really, oil affordability) among potential purchasers of oil. One major cut-off on oil supply is inadequate funds for reinvestment, because of low oil prices.
Why “Oil Prices Don’t Rise High Enough” Is the Real Limit
In my view, our real concern should be the third item above, “Oil Prices Don’t Rise High Enough.” The problem is caused by a mismatch between wages (which are not growing very quickly) and the cost of oil extraction (which is growing quickly). If oil prices rose as fast as extraction costs, they would leave workers with a smaller and smaller percentage of their wages to spend on food, clothing, and other necessities–something that doesn’t work for very long. Let me explain what happens.
Because of diminishing returns, the cost of oil extraction keeps rising. It is hard for oil prices to increase enough to provide an adequate profit for producers, because if they did, workers would get poorer and poorer. In fact, oil prices already seem to be too low. In years past, oil companies found that the price they sold oil for was sufficient (a) to cover the complete costs of extraction, (b) to pay dividends to stockholders, (c) to pay required governmental taxes, and (d) to provide enough funds for investment in new wells, in order to keep production level, or even increase it. Now, because of the rapidly rising cost of new extraction, oil companies are finding that they are coming up short in this process.
Oil companies have begun returning money to stockholders in increased dividends, rather than investing in projects which are likely to be unprofitable at current oil prices. See Oil companies rein in spending to save cash for dividends. If our need for investment dollars is escalating because of diminishing returns in oil extraction, but oil companies are reining in spending for investments because they don’t think they can make an adequate return at current oil prices, this does not bode well for future oil extraction.
A related problem is debt limits for oil companies. If cash flow does not provide sufficient funds for investment, increased debt can be used to make up the difference. The problem is that credit limits are soon reached, leading to a need to cut back on new projects. This is particularly a concern where high cost investment is concerned, such as oil from shale formations. A rise in interest rates would also be a problem, because it would raise costs, leading to a higher required oil price for profitability. The debt problem affects high priced oil investments in other countries as well. OGX, the second largest oil company in Brazil, recently filed for bankruptcy, after it ran up too much debt.
National oil companies don’t explain that they are finding it hard to generate enough cash flow for further investment. They also don’t explain that they are having a hard time finding sites to drill that will be profitable at current prices. Instead, we are seeing more countries with national oil companies looking for outside investors, including Brazil andMexico. Brazil received only one bid, and that for the minimum amount, indicating that oil companies making the bids do not have high confidence that investment will be profitable, either. Meanwhile, newspapers spin the story in a totally misleading way, such as, Mexico Gears Up for an Oil Boom of Its Own.
US natural gas is another product with a similar problem: the price is not high enough to justify new production, especially for shale gas producers. The huge resource that some say is there is simply too expensive to extract at current prices. Would-be natural gas producers cannot tell us this. Instead, we find a recent quote in the Wall Street Journal saying:
“We are not dealing with an era of scarcity, we are dealing with a situation of abundance,” Ken Cohen, Exxon’s vice president of public and government affairs, said in an interview. “We need to rethink the regulatory scheme and the statutory scheme on the books.”
Cohen could explain that without natural gas exports, there is no way the natural gas price will rise high enough for Exxon-Mobil to extract the resource at a profit. Without exports, Exxon Mobil will lose money on the extraction, or more likely, will have to leave the natural gas in the ground. With low prices, the huge resource that Obama has talked about is simply a myth–the prices need to be higher. Of course, no one tells us the real story–it seems better to let people think that the issue is too much natural gas, not that it can’t be extracted at the current price. The stories offered to the news media are simply ways to convince us that exports make sense. Readers are not aware how much stories can be “spun” to make the current situation sound quite different from what it really is.
What Goes Wrong with “Climate Change” and “Limit Based on Geology” Views
The Illusion of Reserves. Oil and gas reserves may seem to be “be there,” but a lot of conditions need to be in place for them to actually be extracted. Clearly, the price needs to be high enough, both for current extraction and to fund new investment. Other conditions need to be in place as well: Debt needs to be available, and it needs to be available at a sufficiently low rate of interest to keep costs down. There needs to be political stability in the country in question. Something as simple as a continuation of the uprisings associated with the Arab Spring of 2010 could lead to the inability to extract reserves that seem to be present. Other requirements include availability of water for fracking and the availability of skilled workers and drilling rigs.
In the past, we have been far enough away from limits that issues such as these have not been a big problem. But as we get closer to limits and stretch our capabilities, these become more of a problem. Right now, availability of debt at low interest rates is a particularly important issue, as is the need for adequate oil company profitability–things that are easy to overlook.
Wrong Economic Views Leading to Wrong Oil Views. Economists have put together economic models based on a world without limits. A world without limits is the easy approach, because mathematical relationships are much simpler in a world without limits: a relationship which held in 1800 is expected to hold in 1970 or in 2050. A world without limits never offends politicians, because growth always seems to be possible, meaning a never-ending supply of jobs and of goods and services for constituents. A model without limits produces the simple relationships that we are accustomed to, such as “Inadequate supply will lead to a rise in price, and this in turn will tend to create greater supply or substitutes.” Unfortunately, these models omit many important variables and thus are inadequate representations of the world we live in today.
In a world with limits, there are feedback loops that cause high oil prices to lead to lower wages and more unemployment in oil importing countries. Thus “demand” can’t keep rising, because workers can’t afford the higher oil prices. Oil prices stagnate at a level that is too low to maintain adequate investment. High oil prices also feed back into slower economic growth and a need for ultra-low interest rates to raise demand for high-priced goods such as cars and homes.
When prices remain in the $100 barrel range, they are still high enough to damage the economy. Businesses are not much damaged, because they have ways they can work around higher oil prices, especially if interest rates are low. Most of the ways businesses can work around high oil prices involve reducing wages to US workers–for example, outsourcing production to a lower cost country, or cutting the pay of workers, or laying off workers to match lower demand for goods. (Lower demand for goods tends to occur when oil prices rise, and businesses raise their prices to reflect the higher oil costs.)
Workers are still affected by costs in the $100 barrel range, and so are governments. Governments must pay out higher benefits than in the past, to keep the economy afloat. They must also keep interest rates very low, to try to keep demand for homes and cars as high as possible. The situation becomes very unstable, however, because very low interest rates depend on Quantitative Easing, and it does not appear to be possible to continue Quantitative Easing forever. Thus, interest rates will need to rise. Such a rise in interest rates is likely to push the country back into recession, because taxes will need to be higher (to cover the government’s higher debt costs) and because monthly payments on homes and new car purchases will tend to rise. The limit on oil production then becomes something very remote from geology–something like, “How long can interest rates remain low?” or “How long can we make our current economy function?”
The Interconnected Nature of the Economy. In my last post, I talked about the economy being a complex adaptive system. It is built from many parts (many businesses, laws, consumers, traditions, built infrastructure). It can operate within a range of conditions, but beyond that range it is subject to collapse. An ecosystem is a complex adaptive system. So is a human being, or any other kind of animal. Animals die when their complex adaptive system moves out of its range.
It is this interconnectedness of the economy that leads to the strange situation where something very remote from the real problem (oil limits) can lead to a collapse. Thus, it can be a rise in interest rates or a political collapse that ultimately brings the system down. The path of the downslope can be very different from what a person might expect, based on the naive view that the problems will simply relate to reduced supply of oil.
A Case Study of the Collapse of the Former Soviet Union
The Soviet Union was major oil exporter and a military rival of the United States in the 1950s through 1980s. It also was the center of a huge economic system, involving many other countries. One thing that bound the countries together was the use of communism as its method of government; another was trade among countries. In effect, the group of communist countries had their own complex adaptive system. Things seemed to go fine for many years, but then in December 1991, the central government of the Soviet Union was dissolved, leaving the individual republics that made up the Former Soviet Union (FSU) on their own.
While there are many theories as to what all caused the collapse, it seems to me that low prices of oil played a major role. The reason why low oil prices are important is because in an oil exporting country, such as the FSU, oil export revenues represent a major part of government funding. If oil prices drop too low, there is a double problem: (1) it becomes unprofitable to drill new wells, so production drops and, (2) the revenue that is collected on existing wells drops too low. The problem is then a huge financial problem–not too different from the financial problem the US and many of the big oil importing countries are experiencing today.
Figure 1. Oil production and price of the Former Soviet Union, based on BP Statistical Review of World Energy 2013.
In this particular situation, oil prices (in inflation adjusted prices) hit a peak in 1980. Once oil prices hit a peak, FSU oil production very much flattened. There was a continued small rise until 1983, but without the very high prices available until 1980, aggressive investment in new oil extraction dropped back.
Not only did FSU oil production flatten, but FSU oil consumption also flattened, not long after oil production stopped rising (Figure 2). This flattening helped maintain exports and the taxes that could be collected on these exports.
Figure 2. Former Soviet Union Oil Production and Consumption, based on BP Statistical Review of World Energy, 2013.
Even though total exports were close to flat in the 1980s (difference between consumption and production), there were some countries where exports that were rising–for example North Korea, shown in Figure 4. This mean that oil exports for some allies needed to be cut back as early as 1981. Figure 3 shows the trend in oil consumption for some of FSU’s allies.
Figure 3. Oil consumption as a percentage of 1980 consumption for Hungary, Romania, and Bulgaria, based on EIA data.
A person can see that oil consumption dropped off slowly at first, and increased around 1990. All of these countries saw their oil consumption drop by at least 40% by 2000. Bulgaria saw is oil consumption drop by 65% to 70%.
The FSU exported oil to other countries as well. Two countries that we often hear about, Cuba and North Korea, were not affected in the 1980s (Figure 4). In fact, Cuba’s oil consumption never seems to have been severely affected. (It is possible that exports of manufactured goods from the FSU dropped, however.) Cuba’s drop-off in oil consumption since 2005 may be price-related.
Figure 4. Oil consumption as a percentage of 1980 oil consumption for Cuba and North Korea, based on EIA data.
North Korea’s oil consumption continued growing until 1991. Its drop-off was then very severe–a total of an 83% reduction between 1991 and 2010. In most of the countries where oil consumption dropped, consumption of other fossil fuels dropped as well, but generally not by as large percentages. North Korea experienced nearly a 50% drop in other fuel (mostly coal) consumption by 1998, but this has since somewhat reversed.
By 1991, the FSU was in poor financial condition, partly because of the low oil prices, and partly because its oil exports had started dropping. FSU’s oil production left its plateau and started dropping about 1988 (Figure 2). The actual drop in FSU oil production meant that oil consumption for the FSU needed to drop as well–a big problem because industry depended upon this oil. The break-up of the FSU was a solution to these problems because (1) it eliminated the cost of the extra layer of government and (2) it made it easier to shift oil consumption among the member republics, so that those republics that produced more oil could keep it for their own use, rather than sending it to republics which did not produce oil. This shortchanged non-oil producing republics, such as the Ukraine and Belarus.
If we look at oil consumption for a few of the republics that were previously part of the FSU, we see that oil consumption was fairly flat, then dropped off quickly, after 1991.
Figure 5. Oil consumption as a percentage of 1985 oil production for Russia, the Ukraine, and Belarus, based on BP Statistical Review of World Energy 2013.
By 1996 (only 5 years after 1991), oil consumption had dropped by 78% for the Ukraine, by 61% for Belarus, and by “only” 47% for Russia, which is an oil-producing state. At least part of the reason for the fast drop off was the fact that in the years immediately after 1991, oil production for the FSU dropped by about 10% per year, necessitating a quick drop off in consumption, especially if the country was to continue to make some money from exports. The 10% drop-off in oil production suggests that the decline in oil production was more than would be expected from geological decline alone. If the decline were for geological reasons only, without new drilling, one might the expect the drop off to be in the 4% to 6% range.
When oil consumption dropped greatly, population tended to decline (Figure 6). The decline started earliest in the countries where the oil consumption drop was earliest (Hungary, Romania, and Bulgaria). The steepest drop-offs in population occur in the Ukraine and Bulgaria–the countries with the largest percentage drops in oil consumption.
Figure 6. Population as percent of 1985 population, for selected countries, based on EIA data.
Some of the population drop is from emigration. Some of it is from poorer health conditions. For example, Russia used to provide potable water for its citizens, but it no longer does. Some is from conditions such as alcoholism. I haven’t shown the population change for North Korea. It actually continued to increase, but at a much lower rate of growth than previously. Cuba’s population has begun to fall since 2005.
GDP growth for the countries shown has tended to lag behind world economic growth (Figure 7).
Figure 7. GDP compared to world GDP – Change since 1985, based on USDA Real GDP data.
Nearly all of the countries listed above have had financial problems, at different times.
Belarus’s GDP seems to be doing better than the rest on Figure 7. Belarus, like the Ukraine, is a pipeline transit country for Russia. In Belarus, natural gas consumption has increased, even as oil consumption has decreased. This increase is likely helping the country industrialize. Inflation occurred at the rate of 51.9% in 2012 according to the CIA World Fact Book. This high inflation rate may be distorting indications.
We can’t know exactly what path our economy will follow in the future. I expect, though, that the path of the FSU and its trading partners is closer to the path we will be following than most forecasts we hear today. Most of us haven’t followed the FSU story closely, because we wrote off most of their problems to deficiencies of communism, without realizing that there was a major oil component as well.
The FSU situation may, in fact, be better that what the Industrialized West is facing in the next few years. The FSU had the rest of the world to support it, offering investment capital and new models for development. Oil production for Russia was able to rebound when oil prices rose again in the early 2000s. As situations around the world decline, it will be harder to “bootstrap.”
One of the things that hampered the recovery of the FSU was the fact that the communist economic model proved not to be competitive with the capitalistic model. In a way, the situation we are facing today is not all that different, except that our challenge this time is competition from Asian economies that we have not had to compete with until the early 2000s.
Asian economies have several cost advantages relative to the Industrialized West:
(1) Asian competitor countries are generally warmer than the industrialized West. Because of this, Asian workers can live more comfortably in flimsy homes. They also don’t need much salary to cover heating and can more easily commute by bicycle. It is often possible to produce two crops a year, making productivity of land and of farmers higher than it otherwise would be. In other words, Asian competitor countries have an energy subsidy from the sun that the Industrialized West does not.
(2) Asian competitors are often willing to ignore pollution problems, reducing their costs relative to the West.
(3) Asian competitors generally depend on coal to a greater extent than we do, keeping their costs down, relative to countries that use higher-priced fuels.
(4) Asian competitors are less generous with employee benefits such as health care and pensions, also holding costs down.
Economists, through their wholehearted endorsement of globalization, have pushed industrialized countries into a competitive situation which we are certain to lose. While oil prices tend to push wages down, competition with Asian countries makes the downward push on wages even greater. These lower wages are part of what are pushing us toward collapse.
To solve our problems, economists have proposed a shift toward renewable energy and the implementation of carbon taxes. Unless these changes are done in a way that actually reduces costs, these “solutions” are likely to make us even less competitive with low-cost competitors such as those in Asia. Thus, they are likely to push us toward collapse more quickly.
To support this position, economists point to climate change models based on the view that the burning of fossil fuels will increase greatly in the decades again. In fact, if collapse occurs in the next few years in the Industrialized West, carbon emissions are likely to fall quickly. Because of the interconnectedness of the world system, the rest of the world will likely also encounter collapse in not many more years, and their carbon emissions are likely to fall quickly, as well. Even the “Peak Oil” emissions that are used in climate change models are way too high, relative to what seems likely to be the case.
If I am right about collapse being a possibility for the Industrialized West, then our problem will be that we as nations become so poor that we can no longer find goods to trade with Asian countries. Most of our goods will not be competitive as exports, and we won’t be able to simply add more debt to rectify the situation. Thus, we will become unable to buy many goods we depend on, including computers and replacement parts for wind turbines.
Breakups of many types are possible. The European Union may cease to operate in the way it does today. The International Monetary Fund is likely to cease operating in the way it does today, because of the collapse of many of its members who provide funding. The US will be subject to strains of the type that lead to break up. If nothing else, oil producing states will want to withdraw, so that they are not, in effect, subsidizing the rest of the US economy.
It is unfortunate that economists are tied to their hopelessly out-of-date economic models. Part of the problem is that the story of “collapse around the corner” doesn’t sell well. The alternate story economists have come up with really isn’t right, but it is pleasing to the many who benefit from subsidies for renewables, and it makes politicians look like they are doing something. The specter of climate change in the distance gives an excuse to cut back oil use, among other things, so has at least some theoretical benefit.
It is unfortunate, however, that we cannot look at the real problem. Unless we can understand the problem as it really is, it is impossible to find solutions that might actually be helpful.
An economist recently recommended that I read a paper by three Fed researchers titled: “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis.” It was presented at a major conference last year and made the rounds again in the economics blogosphere this year with generally positive reviews. It seems to have been influential.
The authors – Christopher Foote, Kristopher Gerardi and Paul Willen – argue that the financial crisis was caused by over-optimistic expectations for house prices, while other factors such as distorted incentives for bankers played only minor roles or no roles at all. In other words, it was a bubble just like the Dutch tulip mania of the 1630s or South Sea bubble of the early 1700s, and had nothing to do with modern financial practices.
Then the authors make absolutely sure of their work being well-received by those who matter. The financial crisis is surely a touchy subject at the Fed, where the biggest PR challenge is “bubble blowing” criticism from those of us who aren’t on the payroll (directly or indirectly). But Foote, Gerardi and Willen are, of course, on the payroll. They tell us there’s little else that can be said about the origins of the crisis, because any “honest economist” will admit to not understanding bubbles.
Here’s their story:
[I]t is deeply unsatisfying to explain the bad decisions of both borrowers and lenders with a bubble without explaining how the bubble arose. …Unfortunately, the study of bubbles is too young to provide much guidance on this point. For now, we have no choice but to plead ignorance, and we believe that all honest economists should do the same. But acknowledging what we don’t know should not blind us to what we do know: the bursting of a massive and unsustainable housing bubble in the U.S. housing market caused the financial crisis.
We don’t often critique papers like this (who cares about Fed research outside of academic economists?) But what the heck, the bolded sentences above – in particular, the hypocritical reference to “honest economists” – deserve at least a few words of rebuttal.
We’ll limit our comments to two areas. First, we’ll offer a redline edited version of a key section in the authors’ conclusion, mostly to share a different perspective on the financial crisis. Second, we’ll point out an example of dishonesty from these economists who brazenly claim that their own perspective is the only one that can be called honest.
Where did the bubble come from?
In practice, the authors don’t completely “plead ignorance” about the causes of bubbles as they claim to do. They offer a few “speculative” ideas about the housing bubble, writing:
One speculative story begins with the idea that some fundamental determinants of housing prices caused them to move higher early in the boom. Perhaps the accommodative monetary policy used to fight the 2001 recession, or higher savings rates among developing countries, pushed U.S. interest rates lower and thereby pushed U.S. housing prices higher. Additionally, after the steep stock market decline of the early 2000s, U.S. investors may have been attracted to real estate because it appeared to offer less risk. The decisions of Fannie Mae and Freddie Mac may have also played a role in supporting higher prices…
This smells to us like a strategy of gently acknowledging criticism (of the Fed’s interest rate policies), while at the same time attempting to neutralize it. The authors imply that low interest rates were an unavoidable byproduct of the Fed’s recession fighting, and then shift some of the blame to foreigners in developing countries before moving on to other possible explanations.
But even if you believe the Fed’s anti-recession measures were worthwhile, the authors’ story is nonsense. It needs corrections for the facts that the Fed continued to slash rates nearly two years after the 2001 recession and then maintained an ultra-easy stance for a few years after that. It also begs the question of why the Fed responded to high foreign savings rates – which were the flip side to U.S. current account deficits and primary source of disinflation – with even greater stimulus. Moreover, there’s much more to the Fed’s role in the housing boom than these factors.
As we see it, the financial crisis validated certain principles that aren’t reflected in mainstream models but feature in fringe areas such as Austrian business cycle theory orbehavioral economics. Economists in these areas offer far more detailed explanations for the housing bubble than the “speculative story” above. For example, recent Nobel Prize winner Robert Shiller filled a whole book with bubble theories. While Foote, Gerardi and Willen would presumably call these economists dishonest, we beg to differ. Borrowing from non-mainstream ideas, here’s our edited version of the excerpt:
If this version is accurate, the Fed’s failures include three whoppers:
- Monetary policy was too stimulative throughout the boom.
- Two decades of Greenspan/Bernanke “puts” created a mentality that risky bets couldn’t lose (moral hazard).
- The Fed applauded rather than stopping the deterioration in lending standards, blithely disregarding its status as only institution that was mandated to set nation-wide lending requirements.
As you might expect, Foote, Girardi and Willen weave a story that either denies or diverts attention from all three failures. One part of the story is their claim that bubbles can’t be explained and anyone who thinks otherwise is dishonest. If the defining feature of the crisis can’t be explained, then it can’t be blamed on the Fed, right?
Other parts of the story are embedded in 12 “facts” that are said to describe the crisis. As written, many of the “facts” are strictly true. Some may have even added to the public debate because they weren’t widely known in policy circles, even as they were understood in the fixed income business. Others, though, can only distort that debate. The worst of the so-called facts are somewhere in between flat wrong and technically accurate but interpreted in ways that don’t stand up to scrutiny.
Lending standards didn’t really change during the boom?!?
We’ll point out a single example, from pages 9-11 of the paper and sub-titled, “Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005.” In this section, the authors deny that policymakers dropped the ball on lending standards. They don’t mention central bankers explicitly (that would be too obvious?), choosing instead to absolve the Clinton administration of blame for its ill-fated National Home Ownership strategy. Of course, their argument also exonerates the Fed if you happen to believe it.
The argument depends partly on a history lesson that begins like this:
It is true that large downpayments were once required to purchase homes in the United States. It is also true that the federal government was instrumental in reducing required downpayments in an effort to expand homeownership. The problem for the bad government theory is that the timing of government involvement is almost exactly 50 years off. The key event was the Servicemen’s Readjustment Act of 1944, better known as the GI Bill, in which the federal government promised to take a first-loss position equal to 50 percent of the mortgage balance, up to $2,000, on mortgages originated to returning veterans.
The authors then tell a nostalgic tale about loan-to-value (LTV) ratios in the 1950s and 1960s, before skipping ahead to the 1990s and 2000s. For the latter period, we’re told to believe that lending standards didn’t decline in a meaningful way:
Figure 6 shows LTV ratios for purchase mortgages in Massachusetts from 1990 to 2010, the period when government intervention is supposed to have caused so much trouble … But inspection of Figure 6 does not support the assertion that underwriting behavior was significantly changed by that program [Clinton’s National Homeownership Strategy].
Here’s the key chart that goes with this claim:
Here are a few reasons why the thesis doesn’t fit the reality:
- The authors share data for only one state (Massachusetts), while failing to mention that it didn’t have much of a housing bust. Consider that Boston is one of only four cities (out of 20) in the S&P/Case-Shiller Home Price Index for which prices didn’t fall by more than 20%. During the bear market period for the full index, the Boston component fell only 16%, less than half the 34% drop in the national index.
- The authors’ sweeping argument relies on not only a single state, but also a single indicator (LTV ratios). You might wonder: What were the credit scores of borrowers at each LTV level? How did their incomes compare to monthly mortgage payments? Were their incomes verified? These types of questions need answers before you can draw general conclusions about underwriting behavior.
- Even the cherry-picked data – Massachusetts LTV ratios! – doesn’t support the authors’ conclusions. It shows that the incidence of ratios greater than 100% tripled during the housing boom, from about 8% of all Massachusetts mortgages to about 25%. The claim that this change isn’t significant is incredulous.
- LTV ratios in the 1950s and 1960s, while interesting, are irrelevant to the early 21stcentury housing boom. Different era, different circumstances, different implications.
Needless to say, the authors’ attempt at defending fellow public officials falls well short. Lending standards declined sharply during the boom, and this was encouraged by both the federal government and the Fed. No amount of data mining can change these facts.
Overall, the Fed staffers’ paper fits a common pattern. It’s stuffed with enough data to be taken seriously, but inferences are based more on spin than objective analysis. The approach aligns conclusions with an establishment narrative, while protecting the authors’ establishment status. The last thing you would call this paper is an honest piece of research.
As long as we’re at it, here’s an extra edit, this one offering another perspective on Foote, Gerardi and Willen’s conclusions about our knowledge of bubbles (from the first excerpt above):
There is a currently a window of opportunity open for Canada to set up shipping of natural gas to Asia, says former federal industry minister Jim Prentice, but it will have to move quickly to stay abreast of U.S. competition.
Prentice, now a vice-president at CIBC, says there is some urgency for Canada to adjust to the new reality of the North American energy market, in which the U.S. is a major producer.
“We’ve gone from being a comfortable natural gas producer to the U.S., to now competing with the U.S.,” he in an interview with CBC’s Lang & O’Leary Exchange.
“The changes that have driven all this, the technological changes have taken place so quickly, I think it caught people off guard,” he said.
There is now considered to be a glut of natural gas production in North America because of new technology that allows the capture of shale gas.
‘We are going from being a continental energy producer to being a global energy player. And in order to do that we have to secure market access’– Jim Prentice
There are severalproposals for liquefied natural gas terminals to export from British Columbia to markets in China, Japan and India, but nothing is near being realized.
Prentice acknowledged that the projects require multi-billion-dollar financial commitments, but says Canada risks losing out to the U.S., which has moved faster on buiiding natural gas shipping terminals.
“People are only going to launch those kinds of projects if they have the certainty they require and that relates to the royalty regime, that relates to the fiscal regime, that relates to their capacity to export. These are all things we’re good at as Canadians, but we need to make sure we’re focused on it,” he said.
His comments came the same day that Exxon Mobile Corp is predicting worldwide demand for natural gas will jump 65 per cent over the next 25 years.
Exxon issued its annual review of energy supply and demand, a closely watched report that sets the course for production and alerts policymakers to the changes they might have to prepare for.
Exxon, the U.S. largest gas producer, is preparing for surging demand from developing countries, even as developed countries embrace emissions controls and greater energy efficiency.
Natural gas prices fall
Natural gas prices have been falling as the U.S. production of shale gas surges. That has prompted some Canadian energy firms to reduce their exposure to natural gas.
Prentice said Canada has to be prepared to invest in the opportunities for Canadian energy opening up overseas.
“The world is awash in natural gas, what it doesn’t have is an ample supply of stable nation states that can fulfill contracts over a 50 year period – that’s what’s needed,” he said.
“We are going from being a continental energy producer to being a global energy player. And in order to do that we have to secure market access,” he added.
Prentice said he is optimistic that the correct groundwork is being laid to complete projects such as LNG terminals on the West Coast and the Northern Gateway pipeline. He has urged the federal government to continue to engage with First Nations in communities that will be affected by the projects.
The long-term outlook by Exxon predicts that world energy demand will grow 35 per cent by 2040.
“People want a warm home, a refrigerator, a TV, someday a car, and a cellphone,” said William Colton, Exxon’s vice-president for corporate strategic planning.
Among its predictions:
- Oil demand will rise 25 per cent by 2040 as it will remain “the fuel of choice for transportation.”
- Deepwater, oilsands and shale oil production will be necessary to meet demand.
- Demand for coal will rise until 2015, but fall by 2040 as countries abandon coal-fired power.
- Nuclear power will see “solid growth.”
- Supplies of renewable energy will increase nearly 60 per cent by 2040, led by increases in hydro, wind and solar.
Exxon prefaced its long-term outlook report with a call to lift the U.S. ban on exporting domestic crude oil, which dates back to the 1973 oil crisis.
Ken Cohen, Exxon’s vice president of public and government affairs, told the Wall Street Journal the ban no longer makes sense because the U.S. is “dealing with a situation of abundance.”
If You Don’t Trust the Fed, Here’s an Inside View That Confirms Your Worst Suspicions | CYNICONOMICS
If You Don’t Trust the Fed, Here’s an Inside View That Confirms Your Worst Suspicions
Earlier this year the notion that the Fed might modestly taper its purchases drove significant upheaval across financial markets. This episode should engender humility on all sides. It should also correct the misimpression that QE is anything other than an untested, incomplete experiment.
– Former FOMC Governor Kevin Warsh, writing in the Wall Street Journal on November 13.
If I may paraphrase a sainted figure for many of my colleagues, John Maynard Keynes: If the members of the FOMC could manage to get themselves to once again be thought of as humble, competent people on the level of dentists, that would be splendid. I would argue that the time to reassume a more humble central banker persona is upon us.
– Dallas Fed President Richard Fisher, speaking in Chicago on December 9.
I fault the Fed for its lack of intellectual leadership on the economy and, in particular, Bernanke’s lack of forthrightness about the limits of the Fed’s ability to address slow growth and fiscal disequilibrium.
– Former St. Louis Fed President William Poole, speaking in Washington D.C. on March 7.
Does anyone else see a common theme?
Last month, we offered a plain language translation of the Warsh op-ed, because we thought it was too carefully worded and left readers wondering what he really wanted to say. Translation wasn’t necessary for Fisher’s speech, which contained a clear no-confidence vote in the Fed’s QE program. Poole’s comment was from a seminar question-and-answer session earlier this year, but it reached our inbox only last week in a transcript published in the latest Financial Analysts Journal. The Q&A was attached to an article that I’ll discuss here, because it makes claims we haven’t heard from others with FOMC experience.
Here’s an example:
Ben Bernanke talks a lot about risk management and the tradeoff between benefits and costs; he maintains that the need to balance these two issues justifies proceeding with the current policy. But Bernanke does not discuss the risk of political intervention in Fed policy despite numerous examples of the Fed giving in to political pressure and waiting too long to change its policy, which results in a detrimental outcome for the economy.
Essentially, pressure on the Fed will come from inside the government and may not be very visible; it may be limited to a few op-ed articles from the housing lobby. [FFW – presumably, Poole intended “it” to refer to the visible part of the pressure.] The true amount of political pressure will be largely hidden.
Poole is more or less saying that we have no idea what’s truly behind the Fed’s decisions. But he doesn’t stop there. He’s willing to make a prediction that you wouldn’t expect from an establishment economist:
[T]he real issue is the politics of monetary policy … I believe that the Fed will not successfully resist the political winds that buffet it. I am not a political expert or a political analyst by trade. My qualification for speaking on this topic is that I have followed the interactions between monetary policy and politics for a very long time. As with all things political, the politics of the Fed means that realities often fail to match outward appearances … I believe the Fed is likely to overdo its current QE policy of purchasing $45 billion of Treasuries and $40 billion of MBSs per month.
So there you have it: a 10-year FOMC veteran wants us to know that central banking isn’t all about the latest hot research on the wonders of unconventional measures. On the contrary, monetary policy is no different than other types of policymaking; it’s guided by hidden political forces.
If you don’t mind our saying so, we feel a bit vindicated. Our very first Fed post ten months ago included the following:
As for the flip-flop [the Fed’s commitment to lifting the stock market through QE so shortly after claiming no responsibility for stock prices in recent bubbles], it’s easy to find a logical explanation. The banks want QE. Influential political and economic leaders want QE. Therefore, the path of least resistance is to give them QE. On the other hand, market manipulation to prick the Internet and housing bubbles would have been widely unpopular. Therefore, policymakers rejected the idea that they should manipulate markets and prick bubbles. No one likes to be unpopular.
More generally, QE seems to me to be explained by Bernanke (and his colleagues) being unable to sit still. This is natural behavior when you have to continually justify decisions. It’s not easy to explain to Congress, the media or public why you’re doing nothing but waiting for past policies to work. It won’t be long before people portray you as weak and indecisive and tell you to “Get to work, Mr. Chairman.” But once you start implementing new policies, especially if they’re in a direction that’s expedient for everyone in the short-term, then those criticisms go away. They’re replaced by adjectives like bold and proactive. And who doesn’t want to be known as bold and proactive?
We haven’t returned to this theme often, partly because it can’t be tested like we can test the Fed’s economic beliefs. Regular readers know that we do quite a lot of empirical work. We try our best to follow David Hume’s maxim that: “A wise man, therefore, proportions his belief to the evidence.”
As we see it, the Fed’s economic beliefs are proportioned more closely to political factors than real-life evidence. You might replace Hume with Upton Sinclair, who said “it is difficult to get a man to understand something when his salary depends on him not understanding it.”
In other words, politics and personal incentives are a huge part of the picture, and not just in central banking but in the economics profession more generally.
The theories underpinning current policies, which have built up over the last 80 years or so, can’t be properly understood without thinking through the motivations behind key developments. Some of the motivational factors are obvious, while others are more subtle, but I won’t clutter this post with our musings on the hidden drivers in economics. Detlev Schlichter offered a nice summary in his book, Paper Money Collapse:
It would be naïve to simply assume that the exalted position of [mainstream economic] theories in present debate is the result of their superiority in the realm of pure sciences. This is not meant as a conspiracy theory in the sense that professional economists are being hired specifically to develop useful theories for the privileged money producers in order to portray their money printing as universally beneficial. But it would be equally wrong to assume that the battle for ideas is fought only by dispassionate and objective truth-seekers in ivory towers and that only the best theories are handed down to the decision makers in the real world, and that therefore whatever forms the basis of current mainstream discussion must be the best and most accurate theory available. No science operates in a vacuum. The social sciences in particular are often influenced in terms of their focus and method of inquiry by larger cultural and intellectual trends in society. This is probably more readily accepted in the other major social science, history. What questions research asks of the historical record, what areas of inquiry are deemed most pressing and how historians go about historical analysis is often shaped by factors that lie outside the field of science proper and that reflect broader social and political forces.
Moreover, ever since mankind began writing its histories they have served political ends. History frequently provides a narrative for the polity that gives it a sense of identity or purpose, whether this is justified or not, and the dominant interpretations of history can be powerful influences on present politics. Similarly, certain economic theories have become to dominate debate on economic issues because they fit the zeitgeist and specific political ideologies. This is not to say that economics cannot be a pure, objective science. It certainly can and should be. Whether theories are correct or not must be decided by scientific inquiry and debate, and not in the arena of politics and public opinion. But it is certainly true that many economists do depend for their livelihoods on politics and public opinion, and that they cannot operate independently of them.
Schlichter is one of many authors and bloggers willing to discuss the awkward realities lurking behind economic theory and central banking. But these ideas are considered taboo by most mainstream media outlets. They’re not discussed in establishment venues or spoken by establishment figures.
Or so I thought.
Poole’s refreshingly honest take on the Fed’s inner workings – from someone who truly knows what goes on behind the curtains – is more than welcome.
“The attitudes toward cannabis are shifting rapidly,” says a former DEA-agent-turned-pot-growing-company-lawyer, adding that “the potential social and financial returns are enormous.” As ironic as that maybe, perhaps it is why Uruguay has just become the first nation in the world to allow its citizens to grow, buy and smoke marijuana. As Reuters reports, the pioneering government-sponsored bill establishes state regulation of the cultivation, distribution and consumption of marijuana and is aimed at wresting the business from criminals. “Our country can’t wait for international consensus on this issue,” said one politician as demand is rising globally as the following chart shows…
DEA Agent becomes Pot-growing-firm lawyer… (via The Atlantic):
Patrick Moen is a 36-year-old former supervisor at the U.S. Drug Enforcement Agency, where, until recently, he led a team based in Portland that fought methamphetamine and heroin traffickers.
Now, he is embarking on a career change. A rather dramatic one. The Wall Street Journal reports today in a delightful article that Moen has become the in-house lawyer at Privateer Holdings Inc., “a private-equity firm that invests solely in businesses tied to the budding legal marijuana industry.”
In other words, the revolving door between business and government just made an unexpected, and very druggy, turn.
“The potential social and financial returns are enormous,” Moen told the Journal said of his new business. “The attitudes toward cannabis are shifting rapidly.”
Indeed they are.
As Uruguay appears to show (via Reuters):
Uruguay’s Senate is expected to pass a law on Tuesday making the small South American nation the world’s first to allow its citizens to grow, buy and smoke marijuana.
The pioneering government-sponsored bill establishes state regulation of the cultivation, distribution and consumption of marijuana and is aimed at wresting the business from criminals.
Cannabis consumers would be allowed to buy a maximum of 40 grams (1.4 ounces) each month from state-regulated pharmacies as long as they are over the age of 18 and registered on a government database that will monitor their monthly purchases.
Uruguayans would also be allowed to grow up to six plants of marijuana in their homes a year, or as much as 480 grams (about 17 ounces). They could also set up smoking clubs of 15 to 45 members that could grow up to 99 plants per year.
The bill, which opinion polls show is unpopular, passed the lower chamber of Congress in July and is expected to easily pass the Senate on the strength of the ruling coalition’s majority.
“Our country can’t wait for international consensus on this issue,” Senator Roberto Conde of the governing Broad Front left-wing coalition
Rich countries debating legalization of pot are also watching the bill, which philanthropist George Soros has supported as an “experiment” that could provide an alternative to the failed U.S.-led policies of the long “war on drugs.”
“This development in Uruguay is of historic significance,” said Ethan Nadelmann, founder of the Drug Policy Alliance, a leading sponsor of drug policy reform partially funded by Soros through his Open Society Foundation.
“Uruguay is presenting an innovative model for cannabis that will better protect public health and public safety than does the prohibitionist approach,” Nadelmann said.
But who is “using” the most…
So USA is #1 in something!!
“Federal Reserve officials are closer to winding down their controversial $85 billion-a-month bond-purchase program, possibly as early as December, in the wake of Friday’s encouraging jobs report.”
That from the much-deservedly maligned John Hilsenrath, widely regarded to be the Federal Reserve’s ventrioloquist dummy over at the Wall Street Journal, as in, from God’s mouth to the jittery multitudes. Of course the jobs number was just another highly seasoned and over-leavened cupcake from the Bureau of Labor Statistic’s magic hedonic oven, so you can be sure that the predicate of that statement is… how to put it delicately… the latest arrant lie with hypothetical icing on top.
Everybody knows that the Federal Reserve’s money-pumping operations have become a replacement for what used to be an economy. Therefore, no more money pumping = no more so-called economy. It’s that simple. But it doesn’t mean that the Federal Reserve won’t make a gesture and I wouldn’t be surprised if they try it during the season that Santa Claus hovers over the national consciousness — or what little of that remains when you subtract the methedrine, the Kanye downloads, the fear of an $11,000 bill for an emergency room visit requiring three stitches, and all the other epic distractions of our time.
The next meeting of the Fed’s Open Market Committee (FOMC), where such things as taper-or-not are considered, is Dec. 17. The Fed has to make some kind of gesture to retain any credibility, so I suspect they’ll go for a symbolic shaving of five or ten billion a month off the current official bond-buying operation number of $85 billion a month (or $1.2 trillion a year). If they don’t do it, no one will ever believe them again. I call it the “head-fake” taper, because it is essentially a false move.
The catch is that the Fed has more than one back door for vacuuming up all sorts of other miscellaneous financial trash paper securitized by promises already broken, moldy sheet-rock housing, college loans defaulted on, car payments that stopped arriving eighteen months ago, credit cards maxed to oblivion, sovereign foreign economies visibly whirling down the drain, and untold casino bet derivative hedges. Loose talk has it that the Fed is buying up way more dodgy debt than the official number of $85 billion a month. And why not? They bailed out way more than the $700 billion official TARP figure back in 2009 — everything from insolvent European banks to Floridian motels on the REO junk-pile — so nobody should take any particular taper number seriously. They’ll just backfill as necessary.
But even in a world of seemingly no consequence, things happen. One pretty sure thing is rising interest rates, especially when, at the same time as a head-fake taper, foreigners send a torrent of US Treasury paper back to the redemption window. This paper is what other nations, especially in Asia, have been trading to hose up hard assets, including gold and real estate, around the world, and the traders of last resort — the chumps who took US T bonds for boatloads of copper ore or cocoa pods — now have nowhere else to go. China alone announced very loudly last month that US Treasury debt paper was giving them a migraine and they were done buying anymore of it. Japan is in a financial psychotic delirium scarfing up its own debt paper to infinity. Who’s left out there? Burkina Faso and the Kyrgystan Cobblers’ Union Pension Fund? The interest rate on the US 10-year bond is close to bumping up on the ominous 3.0 percent level again. Apart from the effect on car and house loans, readers have pointed out to dim-little-me that the real action will be around the interest rate swaps. Last time this happened, in late summer, the too-big-to-fail banks wobbled from their losses on these bets, providing a glimpse into the aperture of a black hole compressive deflation where cascading chains of unmet promises blow financial systems past the event horizon of universal default and paralysis where money stops moving anywhere and people must seriously reevaluate what money actually is.
I think we’ll see them try the head-fake taper. They must. It will be backstopped by and saturated in statistical lying, and everyone will have trouble parsing the probable effect because the chronic dishonesty loose in this land will have deformed and impaired all metrics of true value. At the heart of whatever remains of this economy is fire, and the officers of the Federal Reserve are playing with it. Pretty soon, we’ll get the un-taper, the final surrender to the crack-up boom that awaits before the western world has to go medieval.
Hunting season is off to a good start this week, and I’m not just talking about deer hunting. It seems that former Fed officials declared open season on their ex-colleagues.
First, Andrew Huszar, who once ran the Fed’s mortgage buying operation, let loose in yesterday’s Wall Street Journal. Huszar apologized to all Americans for his role in the toxic QE programs.
And then today, the WSJ struck again, this time with an op-ed by former FOMC Governor Kevin Warsh.
Instead of excerpting the Huszar essay, we’ll only share the apt words of commenter Ernest Moosa, who wrote:
Every reader needs to understand and grasp what is being said here. We have been on the wrong economic path for five years, and without the desired results, our leadership says “FULL SPEED AHEAD”. We have wasted so much time and money that future generations will point to us and say this is how a great country can be destroyed in less than a decade with no shots even being fired. Deplorable.
Moosa hit the nail on the head, and we recommend reading the op-ed in its entirety if you haven’t already done so.
As for Warsh’s editorial, it was tough to read without wondering what he’s thinking. Warsh is a former Morgan Stanley investment banker whose 2006 to 2011 stint on the FOMC spanned the end of the housing boom and the first few years of “unconventional” policy measures. After such a solid grounding in the ways of the Fed and Wall Street, he recently morphed into a critic of the status quo. His criticisms are welcome and we believe accurate, but they’re also oh so carefully expressed. They’re written with the polite wording and between-the-lines meanings that you might expect from such an establishment figure. He seems to be holding back.
So, what does he really want to say?
Here are our guesses, alongside excerpts from the editorial on each of nine topics that Warsh covered:
“The purchase of long-term assets from the U.S. Treasury to achieve negative real interest rates is extraordinary, an unprecedented change in practice since the Treasury-Fed Accord of 1951.
The Fed is directly influencing the price of long-term Treasurys—the most important asset in the world, the predicate from which virtually all investment decisions are judged. Earlier this year the notion that the Fed might modestly taper its purchases drove significant upheaval across financial markets. This episode should engender humility on all sides. It should also correct the misimpression that QE is anything other than an untested, incomplete experiment.”
What he really wants to say:
We’d all be better off if the central banking gods (myself included) hadn’t been so damn arrogant to think that we actually understood QE. We don’t, and it never should have been attempted.
The Fed’s focus on inflation
“Low measured inflation and anchored inflationary expectations should only begin the discussion about the wisdom of Fed policy, not least because of the long and variable lags between monetary interventions and their effects on the economy. The most pronounced risk of QE is not an outbreak of hyperinflation. Rather, long periods of free money and subsidized credit are associated with significant capital misallocation and malinvestment—which do not augur well for long-term growth or financial stability.”
What he really wants to say:
The inflation target is stupid. It’s not the CPI that’s killing us, it’s the credit booms and busts. The best way out of this mess is to lose the inflation target and go back to the old-fashioned approach of “taking the punch bowl away when the party gets going.”
Pulling off the exit from extraordinary measures
“[T]he foremost attributes needed by the Fed to end its extraordinary interventions and, ultimately, to raise interest rates, are courage and conviction. The Fed has been roundly criticized for providing candy to spur markets higher. Consider the challenge when a steady diet of spinach is on offer.”
What he really wants to say:
Pundits who praise the courage of our central bankers are clueless. The true story is that we consistently take the easy way out. If the current cast of characters wanted to show courage, they’d man up and replace the short-term sugar highs with long-term thinking.
The Fed’s relationship to the rest of Washington
“The administration and Congress are unwilling or unable to agree on tax and spending priorities, or long-term structural reforms. They avoid making tough choices, confident the Fed’s asset purchases will ride to the rescue. In short, the central bank has become the default provider of aggregate demand. But the more the Fed acts, the more it allows elected representatives to stay on the sidelines. The Fed’s weak tea crowds out stronger policy measures that can only be taken by elected officials. Nobel laureate economist Tom Sargent has it right: ‘Monetary policy cannot be coherent unless fiscal policy is.’”
What he really wants to say:
And if we don’t man up, you can count on Congress to continue with its egregious generational theft and destroy our nation’s finances, just as me, Stan and Geoff have been warning.
Who benefits from QE and who doesn’t?
“Most do not question the Fed’s good intentions, but its policies have winners and losers, which should be acknowledged forthrightly.
The Fed buys mortgage-backed securities, thereby providing a direct boost to balance sheet wealth of existing homeowners to the detriment of renters and prospective future homeowners. The Fed buys long-term Treasurys to suppress yields and push investors into riskier assets, thereby boosting U.S. stocks.
The immediate beneficiaries: well-to-do households and established firms with larger balance sheets, larger risk appetites, and access to low-cost credit. The benefits to workers and retirees with significant fixed obligations are far more attenuated. The plodding improvement in the labor markets offers little solace.”
What he really wants to say:
Unbelievably, my ex-colleagues still don’t acknowledge their policies are killing the middle class to the benefit of the plutocracy. Their silence on this is wholly unacceptable and has to stop (and so do the policies).
Domestic versus global policy considerations
“[T]he U.S. is the linchpin of an integrated global economy. Fed-induced liquidity spreads to the rest of the world through trade and banking channels, capital and investment flows, and financial-market arbitrage. Aggressive easing by the Fed can be contagious, inclining other central banks to ease as well to stay competitive. The privilege of having the dollar as the world’s reserve currency demands a broad view of global economic and financial-market developments. Otherwise, this privilege could be squandered.”
What he really wants to say:
We really need to climb out of our shell and look at things from a global perspective. The rest of the world knows that we’re selling a bill of goods and won’t continue buying it forever. If we don’t change, you can say goodbye to the dollar.
“Since QE began, Fed policy makers have tried to explain that asset purchases and interest rates are different. Hence their refrain that tapering is not tightening, and that very low interest rates will continue after QE. Investors do not agree. Once the Fed begins to wind down its asset purchases, these market participants are likely to reassert their views with considerable force.
Recently, the Fed has elevated forward guidance as a means of persuading investors that it will indeed keep interest rates exceptionally low even after QE. Forward guidance is intended to explain how the central bank will react to incoming data. Fed projections for example, may show below-target inflation and a residual output gap justifying very low interest rates several years from now. But words are not equal to concrete policy action. And the Fed hasn’t received many awards for prescience in recent years.”
What he really wants to say:
Forward guidance is a load of crap. First, you won’t convince the market of any of your dumb ideas. Investors can and will think for themselves. Second, talk is cheap. And talk that’s based on the Fed’s ability to foresee the future? C’mon now, that’s ridiculous.
“[T]ransparency in communications about future policy is not a virtue unto itself. The highest virtue is getting policy right. Given manifest uncertainties about the state of the economy, oversharing policy deliberations is not useful if markets are led astray, or if public commitments reduce policy makers’ flexibility to call things the way they see them.”
What he really wants to say:
Transparency, shmansparency. I’ve had it up to here with taper, untaper, maybe taper, maybe not taper. I’ll trade a transparent central bank for one that knows what it’s doing any day.
Obama’s nomination of Janet Yellen as the next FOMC chair
“The president has nominated a person with a well-deserved reputation for probity and good judgment. The period ahead will demand these qualities in no small measure.”
What he really wants to say:
The president made a bad choice.
These are only our guesses, not actual thoughts from Kevin Warsh, who hasn’t told us what he really wants to say. We don’t even know if he hunts. (We’re guessing no.
Despite the ECB’s recent “stunning” rate cut, which sent the EUR modestly lower by a few hundred pips, the resultant resurge in the European currency has left the European Central Bank even more stunned: just what does it have to do to force its currency lower and boost Europe’s peripheral economies, especially in a world in which every other major central banks is printing boatloads of money each and every month?
We hinted at precisely what the next steps will be two days ago when in “Next From The ECB: Here Comes QE, According To BNP” we said “BNP is ultimately correct as the European experiment will require every weapon in the ECB’s arsenal, and sooner or later the ECB, too, will succumb to the same monetary lunacy that has gripped the rest of the developed world in the ongoing “all in” bet to reflate or bust. All logical arguments that outright monetization of bonds are prohibited by various European charters will be ignored: after all, there is “political capital” at stake, and as Mario Draghi has made it clear there is no “Plan B.” Which means the only question is when will Europe join the lunaprint asylum: for the sake of the systemic reset we hope the answer is sooner rather than later.”
Two days later the answer just appeared when moments ago the WSJ reported that the ECB’s Praet hinted more QE is, just as we predicted, on the table.
The European Central Bank could adopt negative interest rates or purchase assets from banks if needed to lift inflation closer to its target, a top ECB official said, rebutting concerns that the central bank is running out of tools or is unwilling to use them.
“If our mandate is at risk we are going to take all the measures that we think we should take to fulfill that mandate. That’s a very clear signal,” ECB executive board member Peter Praet said in an interview Tuesday with The Wall Street Journal. Annual inflation in the euro zone slowed to 0.7% in October, far below the central bank’s target of just below 2% over the medium term.
He didn’t rule out what some analysts see as the strongest, and most controversial, option: purchases of assets from banks to reduce borrowing costs in the private sector. “The balance-sheet capacity of the central bank can also be used,” said Mr. Praet, whose views carry added weight as he also heads the ECB’s powerful economics division. “This includes outright purchases that any central bank can do.”
The ECB could do more if necessary, Mr. Praet said. “On standard measures, interest rates, we still have room and that would also include the deposit facility,” he said. The central bank’s deposit rate has been set at zero for several months. Making it negative would effectively levy a fee on commercial banks that park funds at the ECB.
The ECB purchased safe bank bonds and government bonds at the height of the global financial crisis and the euro debt crisis, but in small amounts compared with other major central banks.
Of course, there are some legal hurdles:
The ECB’s charter forbids it from financing governments.
But, wily as always, the ECB appears to have found a loophole:
The ECB must respect its legal constraints, Mr. Praet said, however its rules “do not exclude that you intervene in the markets outright.”
And sure enough, the Euro tumbles just as mandated by the ECB’s talking head: let’s see if it actually stays lower this time.
And now check to the Germans, who will be positively giddy that first Europe accused it of unfair export-led growth, and now the ECB is openly contemplating tearing off the Weimar scab.
Looks like things in Europe are about to get exciting all over again.