Sudden Debt

Debt Issuance: Boom to Bust

2011-12-20T11:10:00.002-05:00

A short post today.

First of all, may I wish everyone a very Merry Christmas and Happy New Year.

Secondly, a rather interesting chart (click to enlarge) from the Bank of International Settlements (BIS) latest Quarterly Review.

Global Issuance of Debt Securities Has Collapsed

The global boom of floating trillions of new bonds in 2007-08 has - predictably - become an out and out bust this year, as the credit crisis takes a knife to the appetite for more debt. Notice that the amounts in the charts are net, i.e. after accounting for maturities.

Despite all the talk of massive sovereign bailouts, the figures show that there is very little increase in the total amount of debt outstanding.

Debt of The Financial Sector

2011-11-28T05:06:00.000-05:00

Here's a scary chart, one that I believe explains why the current Debt Crisis merits capitalization, and why it won't go away easily - certainly not by merely "printing" money and giving it to the FIRE sector (finance, insurance, real estate).

USA: Financial Sector Debt Soared Sixteen-fold Between 1952 and 2008

In a most dramatic way, the chart shows that in the United States debt issued and owed by the financial sector (banks, insurers, brokers, etc.) soared to nearly one third of all debt outstanding. A similar pattern is observable across the entire Western economy.

The process gathered steam between 1995 and 2005 because of:

(a) financial speculation (leverage, derivatives, etc) and,
(b) securitization of all manner of bona fide and financially engineered loans, from mortgage debt and credit card receivables, to CDS hybrids (CMO's, CDO's, CPDO's, etc).

The end result was the financial/debt/monetary bubble that burst spectacularly in 2008 - and is still bursting, since the shadow-banking bubble machine has not been shut down.

It is, therefore, highly ironic that the Debt Crisis caused by a virulent out-of-control financial sector has now infected the once safest haven of them all: government debt. Bankers, brokers, money managers and rating agencies - whose inter-connected behinds were collectively rescued from self-immolation three years ago - now lash out at the very governments whose deep pockets (a.k.a. taxpayers) saved their bacon.

Italian Government 10-Year Bond Yield

Putting it another way, the massive expansion of finance and its subsequent collapse is suffocating the world's real economy. We need hundreds of billions of fresh capital to invest in productive projects like energy and network infrastructure, but the FIRE sector is demanding (blackmailing?) that governments continue to dump good money after bad down a bottomless pit, one dug by their own greed and perfidy.

Of course, governments are not innocent babes in this operatic auto-da-fe. First, they foolishly deregulated finance, a notoriously self-serving, risk-loving and cyclical business (for example, by abolishing the Glass-Steagall Act). And then, they kept looking the other way while finance mutated and morphed into a menacing giant, albeit one with extremely weak legs.

It is high time that governments act decisively and forcefully to reverse the "financialization" of the real global economy. We cannot survive, never mind thrive, on the "free-markets" mantras of Wall Street and City alone. The FIRE sector must be forced to de-leverage.

There are many ways to do this: higher capital requirements, strictures on own-account trading, transaction taxes, regulating off-balance sheet derivatives. In my opinion all of them, and more, must be implemented. The purpose is as simple as it is difficult: Kill the beast before it kills us.

Is There Life After Debt?

2011-11-17T04:51:00.000-05:00

Fact: The debt crisis is global - and, yes, this includes the so-called creditor nations, such as China. After all, in our fiat currency world it takes a debit in order to create a credit.

The way we got into this mess is well known: the West foolishly (even criminally, if you ask me) gave up its industrial/manufacturing base and the high earned-income jobs it generated, replacing them with services and low value-added jobs. However, it didn't lower its consuming and spending habits to balance the losses, instead it piled on debt from vendor nations, and constructed Rube Goldberg asset bubble contraptions that attempted to generate "wealth" out of thin air (e.g. real estate, derivative-based bonds, etc.).

Anyone Still Making Anything in the US?

As the chart above shows, the process of de-industrialization is not new, at least not in the U.S. where goods-producing jobs have fallen steadily over the last 60 years, from 40% to 13.8% of total non-farm payrolls. As a direct consequence (in my opinion) wage and salary income has dropped from 68% of total personal income to just a little over 50% (see chart below).

Earned Income Has Dropped Drastically

Consequently, total debt soared to 550% of earned income - even excluding debt of the financial sector (see chart below).

Can The Real Economy Sustain This Debt?

This chart raises one very important question: can the real American (and Western) economy sustain its debt load, or will it collapse under it? To put it another way: Is there life after debt?

The answer to this question involves much more than quantitative easing, classical econometric ratios, or Tea Party dogma. We must go straight to the heart of the global "Permagrowth" economic paradigm, the one we have been using and abusing for well over a century. In this outdated and obviously crumbling model, debt and growth are intrinsically linked, one becoming the enabler for the other in a sort of pushme-pullyou perpetual motion machine.

But it can't go on. Debt is a call on tomorrow's growth - and if such growth is impossible then the debt becomes untenable. The Earth's diminishing resources, benign climate included, can no longer sustain Permagrowth, therefore we cannot repay or even adequately service the immense debt/credit loads we have created.

Yes, there is life after debt. But it will be very different from the consumerist Shangri La we had become used to. I believe we are headed towards a low-intensity, decentralized type of macro-economic paradigm where energy and most consumer goods are produced locally from renewable sources, and where the sociopolitical system is likewise decentralized.

The important question is this: can such a paradigm shift be accomplished relatively smoothly and peacefully, or will it take a major upheaval? I really don't know..

P.S. On the eurozone: Dear Mrs. Merkel (or is it Ms.?), when your entire neighborhood is on fire it is not a good time to argue the bad structure and poor management practices of the Fire Department. Rather, please make sure the firemen have plenty of water and leak-proof hoses.

Ninety-Nine Percent

2011-10-30T02:17:00.001-04:00

In the last 30 years the top 1% of Americans saw their real, after-tax income increase nearly fourfold. And how about the "other" 99%? Look below (click to enlarge)...

One picture is worth a thousand words

The chart appears in an article in The Economist (Income Inequality in America:The 99 Percent), which includes the following passage:

...the data are powerful because they tend to support two prejudices. First, that a system that works well for the very richest has delivered returns on labour that are disappointing for everyone else. Second, that the people at the top have made out like bandits over the past few decades, and that now everyone else must pick up the bill.

Couldn't have said it better myself (and I don't frequently agree with The Economist).

The chart in The Economist article comes from a very interesting study done by the US Congressional Budget Office. The following chart is on its cover.

The Battle For Europe

2011-10-21T05:34:00.003-04:00

From all the news flow out there it appears to me that we are nearing a so-called "inflection" point in the European debt crisis. After a summer and early fall of spinning wheels to no end, European leaders are faced with a stark choice: finally do something serious, or watch the entire euro structure fall apart with unimaginable consequence for the European Union as a whole.

There is a eurozone summit meeting this weekend, to be quickly followed by another one three days later on Wednesday. If the Franco-German axis (no, I do not use the term lightly) does not reach a mutually satisfactory agreement on Greece, expanding the EFSF and bank recapitalization then the inflection will point straight down.

The Battle for Europe is, tragically, being fought by generals who are well out of their depth. They created a continent awash in funny money and a population that for decades felt entitled to their comfortable - albeit debt financed - lifestyle. Oh yes, even the holier than thou Germans; I mean, how else could those "other" Europeans afford to buy millions of BMWs, Airbuses and Miele washers exported by Germany if not through debt? It's not as if Kalamata olives or jamon Serrano have much value-added, after all. And vacations in Terremolinos, Rhodes or Costa Brava are on perennial all-inclusive, cheapest-is-best offer...

Let's Hope It Doesn't Come To This, Again

Europe desperately needs a whole new cadre of strong and decisive leaders who will turn things around. Maybe the current ones will see the light and pave the way for them by gracefully bowing out, after taking whatever steps are necessary right now to forestall implosion. But, I'm not holding my breath..

SNAPpy? Surely Not.

2011-10-06T07:46:00.002-04:00

I occasionally look at the US Dept. of Agriculture data on food stamps (now called Supplemental Nutrition Assistance Program - SNAP) because, in my opinion, it provides a much better "on the ground" feel of the real economy.

It certainly doesn't look snappy.

Data: USDA SNAP

As of July 2011 a record one in seven Americans, or 14.5% of the country's entire population, was receiving food aid. That's far above the 9% mean over the last 30 years.

Steve Jobs

2011-10-06T03:43:00.003-04:00

Steve Jobs, the co-founder of Apple, died yesterday, age 56. He was one of those very few people who changed the world for the better and who will always - and uncommonly - be remembered with admiration and fondness.

Have a Beautiful Trip Steve

Debt 4 More Debt Is 4 Fools

2011-09-23T04:21:00.001-04:00

A full four years after the debt crisis raised its ugly head as a sub-prime loan snafu, it has morphed into a "sovereign debt crisis". And how could it not, since what intervened since then was basically a debt swap. The private sector could not borrow furiously any more, so the government(s) stepped in to take over as the Permagrowth/Permadebt locomotive.

Private Sector Debt: Financial (red), Household (blue) and Corporate (green)

Debt of The Federal Government

In the United States the Federal Reserve printed money with gusto to buy Treasuries, and mortgage securities that no one else would touch.

M2 Money Stock Annual Rate of Change (%)

U.S. Treasuries Held by The Fed

Mortgage Securities Held by The Fed

In plain words, the only reason that the U.S. (and global) economy did not go into a full-fledged deflationary spiral was the printing press and Ben Bernanke's helicopter.

But, like all not-so-very-good things, this too must come to an end; and this time the locomotive is racing towards the end of the line and the hard brick wall known as "the sovereign debt crisis".

Three or four years ago I said that a mild deflationary approach, a small dosage of a bitter medicine judiciously administered would be better than revving up the monetary helicopter: just a touch of Andrew Mellon's "liquidate and purge" , instead of a gross misapplication of Keynes's governmental stimulus. It was counter-intuitive, yes, but along the time-tested lines of don't fight the previous war.

Obviously, it didn't happen, with governments (mostly the US and some of the EU) choosing to fight the private debt crisis with... even more debt of their own.

As this blog's masthead warned, the result was as predictable as mud after a rainstorm. The world now has no more appetite or capacity for even more dubious sovereign debt. There's no one left to borrow or lend in such huge amounts, necessary to keep the Permagrowth/Permadebt model going, and the locomotive itself is in clear danger of being swept under the mud.

4warned we were, alright, but we thought we could a4rd to 4get the hard lessons of history, so now we are becoming fodder 4 fools.

4 shame...

Debt and The Second Law

2011-09-19T00:50:00.004-04:00

A very short post today.

Debt is a call on future earnings, i.e. it presumes there will always be economic "growth" (however you may define it) in order to produce those future streams of income which will service the debt. This is a condition I have called "Permagrowth".

But is it possible?

In the "real" world, where physical fact always trumps populist monetary neo-theology, Permagrowth is impossible by definition. The Second Law of Thermodynamics reigns supreme, i.e. there is no perpetual motion machine - and can never be.

The entropy of the universe tends to a maximum is the "classical" expression of the Second Law, so I come up with a corollary: as the universe always tends to disorder, so debt always tends to default.

In other words, since Permagrowth is impossible so is Permadebt.

P.S. My blog is getting the attention of "comment advertisers", i.e. advertisers who hawk their wares under the guise of "I love your blog" comments. Par for the course, of course, and I usually quickly clean up the comment section. What is interesting, however, is that lately they are hawking gold, gold market tips, etc. Nice contrarian signal, in my opinion.

P.P.S. Speaking of such ballistic charts, in a post four years ago (South Seas and China Seas) I posted the following chart, comparing the famous South Seas Bubble with the price of a (then unnamed) shipping company.

I did not mention the name of the company at the time because I felt it should not be singled out in what was, after all, an industry-wide bubble. Nevertheless, some readers immediately identified the company as Dryships, a bulk-carrier shipping company.

Four years later, this is what happened.

Other than self-congratulation, my point is pretty simple: beware of all bubbles, no matter how "logical" they seem at the time. In fact, the more "logical" they appear the closer they are to bursting. The devil, as always, is in the timing, of course...

Germany's Choice

2011-09-13T07:24:00.000-04:00

Germany is the world's #2 exporter, very close behind China. In 2010 it exported a total of 960 billion euro, amounting to 42% of its GDP. Its trade surplus came to 153 billion euro, almost 7% of GDP. Impressive stuff, no doubt, and an achievement that Germans are justly proud of.

But, not all surpluses are created equal... 35 billion of that surplus, a whopping 23%, was accounted by just four countries: Italy, Spain, Greece and Portugal. Yes, to a very large extent the PIGSs' munching at the trough was what kept Germans working in their factories. And if you just add France, another country that is currently screeching towards the borderline of fiscal probity - at least according to financial markets - the numbers get even more interesting. Germany's PIGS+F trade surplus jumps to 64 billion, a full 42% of Germany's entire trade surplus. In GDP terms (trade surplus is GDP-additive), PIGS+F surplus accounts for nearly 3% of Germany's economy.

Data: Federal Statistical Office

Germany Slurping With The PIGS

However, short-sighted and haphazard German talk of harsh reprisals are turning the country's best customers into pariah states. Recently, a German politician even proposed that eurozone members that can't get their fiscal house in order, raus!, should have their flags fly at half mast at all EU sites. Germany is not making any friends acting in this ham-fisted fashion.

Ah, you may say, Germany doesn't need to coddle dead PIGS anymore and can just export wonderfully advanced stuff to super-charged China. Really? Germany had a whopping 23 billion trade deficit with China in 2010.

German people have a very serious choice to make here, and Mrs. Merkel is furiously waffling instead of leading and speaking clearly. From one side of her mouth she's insisting that she's fully committed to the euro, the eurozone, etc. From the other side emanate dire threats of bankruptcy, default, exit from the eurozone - even the EU itself, all directed at those very PIGS whose consumers are keeping her countrymen happily and gainfully employed.

She's got to tell Germans the truth, at long last: Germany is such an export powerhouse and fiscal icon precisely because the others aren't. It takes two to tango, Mrs. Merkel...

The Joe Engineer Indicator

2011-09-10T03:54:00.002-04:00

Sometime ago I attended an alumni gathering arranged by my old college's Provost. Since he was making the effort to come such a long way I figured I had to go - plus it was good to see old friends again. The reason for this post, however, is not to share maudlin reminiscences (well, maybe a little..).

By way of background, my alma mater was a very competitive place, priding itself of creating "well-rounded" engineers by demanding grueling study and constant testing. Despite the rigour, or perhaps because of it, there was a Marines-like esprit de corps about the place, with few students choosing the easier science and management programs, also on offer. If any less-dedicated students managed to survive freshman year, they were hit with a sophomore year so outrageously demanding that a quarter of the incoming class dropped out. The campus store did a thriving business selling t-shirts with TEXUX emblazoned on them (no, it's not about Texas - phonetic accent is on the "U").

Did I say The Marines? An understatement. The faculty and staff were most aptly comparable to the Spanish Inquisition: you could choose between being converted into Joe Engineer or burning at the stake. On occasion they managed both: the very first student to ever graduate with a perfect 4.0 GPA did it 110 years after the school was founded. He was actually my classmate and during graduation ceremonies some faculty members were so disappointed at the apparent laxity they grumbled the place was going to pot...

Not that we expected anything different, mind you. The very first thing they told us during freshman induction was: "Look to your left, look to your right - four years from now, one of you won't be at graduation". And they were not sad or ashamed about it, either. Oh no, those SOB's were proud if not downright gleeful of their abilities to wean us out mercilessly. It was considered perfectly acceptable to hold mid-term exams on the very first day after spring break. While others hit the Florida beaches, we were expected to hit calculus.

You should have a pretty good picture of the place by now as it was some 30 years ago: Engineer Boot Camp. If you still think I'm exaggerating, how about this: the Dean of Students had the habit of patrolling the dorms at night in the company of a huge dog trained to sniff out controlled substances.

Not A Pet, Tech-nically Speaking

Under the circumstances, my showing up for the Provost's alumni dinner could be better explained by the Stockholm Syndrome...

Imagine my surprise, then, when during the after-dinner presentation the Provost put up a slide showing that most seniors last year (35%) found jobs in.... finance. You could have pushed me over with a feather, because when I graduated my interest in financial markets - and eventual employment at an investment bank - were considered heresy. For many years I was the only member of my class to be employed in finance: almost exactly 0.35%. Go ahead, do the 100-to-1 math, because that's a darn good parallel to the financial and credit cycle from bust to bubble. Though the Provost came to the school years after my graduation and thus did not know me at the time, he called me a "pioneer" during the dinner. I guess I was flattered.

Funny thing is, lately I'm becoming increasingly interested in all things technical. You think...?

Am I a living, breathing Joe Engineer Contrarian Indicator? Could be...

Message To ECB: Why Not Sell CDS, Instead?

2011-09-10T03:32:00.001-04:00

With the European debt crisis threatening to tear apart the very fabric of the EU itself, here's an idea (a weird one, I admit). Instead of buying Italian, Spanish, Greek, etc. government bonds, the ECB could sell the equivalent sovereign credit default swaps (CDS).

Greek CDS Soar

Yes, it means that the central bank will - in effect - guarantee the public debt of such nations, but it will do so only up to a defined limit (the amt. of CDS sold). The benefits, beyond the immediate de-escalation of the crisis, are:

The ECB does not balloon its balance sheet.
No money supply issues (no sterilization needed).
Much bigger bang for the buck through the use of derivatives.
The ECB receives income for the protection sold.

Mr. Stark's resignation yesterday from the ECB board makes it clear there is sharp disagreement within the eurozone itself on how to handle the debt crisis - fair enough. But this doesn't mean that things should be allowed to spin out of control. In such times markets are guided 99.9% by psychology (fear) and cannot be allowed to wreck the entire European socio-economic structure, put together over so many decades.

It's Time To Tax

2011-08-31T01:35:00.008-04:00

The following story appeared in Reuters and made my stomach turn.

Some U.S. firms paid more to CEOs than taxes: study

Here's an excerpt:

"Compensation for the 25 CEOs with pay surpassing corporate taxes averaged $16.7 million, according to the study, compared to a $10.8 million average for S&P 500 CEOs. Among the companies topping the IPS list:

* eBay whose CEO John Donahoe made $12.4 million, but which reported a $131 million refund on its 2010 current U.S. taxes.
* Boeing, which paid CEO Jim McNerney $13.8 billion, sent in $13 million in federal income taxes, and spent $20.8 million on lobbying and campaign spending
* General Electric where CEO Jeff Immelt earned $15.2 million in 2010, while the company got a $3.3 billion federal refund and invested $41.8 million in its own lobbying and political campaigns.

Though the companies come from different industries, their tax breaks fall into two primary areas.

Two-thirds of the firms studied kept their taxes low by utilizing offshore subsidiaries in tax havens such as Bermuda, Singapore and Luxembourg. The remaining companies benefited from accelerated depreciation."

I can fully understand Warren Buffet's call for more (and better structured) taxation. And how else can the U.S. ever get out from under the massive debt pile?

Look at the chart below. If we merely revert to more historically "normal" tax receipts as a percentage of GDP (excluding social insurance which is a completely different issue) the extra revenue will come to some 4% of GDP, or $900 billion per year. The federal budget deficit in 2010 was $1.17 trillion.

Chart: The Big Picture

US Tax Revenue as a Fraction of GDP by Component

The Eurozone: A Family Snapshot

2011-08-26T02:12:00.000-04:00

Given what is going on in the eurozone at the moment, I thought it would be nice to have a snapshot picture of it, circa 2010.

Data: Eurostat (2010)

Ninety percent of the Eurozone's GDP is produced by just seven countries

Before you reach Greece, number 8 on the list with a mere 2.5%, you are already up to 89.99% of total GDP. That is to say, the "black sheep of the family" is a relative spiffle and its fiscal troubles should have been dealt with firmly and - most importantly - FAST. It didn't happen, so the debt crisis has been allowed to fester and spread, threatening to become a serious systemic issue for the entire European Union. A huge mistake for Europe's leaders, particularly Frau Merkel and Monsieur Sarkozi who should have known better. Much better.

After the collapse of the USSR and America's Bush II, it seems that it is now Europe's time to go through its very own Era of Total Ineptness.

History is a harsh mistress whose cycles shall not be disturbed, indeed...

Sudden Debt Redux: Where Are We Now?

2011-08-23T04:23:00.000-04:00

Sudden Debt was started five years ago warning of excess in debt, asset bubbles and the end of the "Permagrowth" model. Today, some of the most egregious excesses have been reversed or at least arrested after wrenching and painful adjustments to the real economy.

Here are some relevant charts (all apply to the United States).

Total debt as a percentage of GDP is still extremely high, but at least it has stopped growing.

The debt service ratio has come down significantly, mostly through rock-bottom interest rates engineered by the Fed.

The personal saving rate is rising, even if only slowly.

Residential real estate, the biggest bubble of them all and Mr. Greenspan's biggest mistake, has burst spectacularly.

The charts above tell me, at least, that the Permagrowth model of the US (and global) economy is finished and must be replaced with something entirely new. I simply cannot imagine that we will just roll over and once again start pumping the same old bubbles of consumption, debt and real estate as remedies for "low growth". History teaches us that it can't be done: once a bubble is burst it stays burst for a long, long time and any attempts to re-inflate it ends in wasted time and resources (Just look at Japan..).

What we need, instead, is a paradigm shift. My choice is to focus on raising earned income and savings, investing the surplus in renewable energy and resource management, basic R&D and technical education.

Gold vs. Debt and GDP

2011-08-17T00:58:00.002-04:00

Continuing a bit from the last post's subject, here's another comparison between gold and US debt: The value of the entire amount of gold in existence in the world vs. total debt of the USA (a proxy for global debt), and global GDP.

According to the World Gold Council there were a cumulative 169,100 tonnes of gold mined by the end of 2010, all of it still in existence since gold practically does not degrade, react, corrode, etc. At the recent high price of $1,800/troy oz. its total market value was $9.8 trillion, or 16% of global GDP.

Using data from the Federal Reserve (US debt) and the US Geological Survey (annual global gold production) I come up with the following chart.

The value of gold is essentially a psychological phenomenon, since it has very few tangible uses. At 15% of global GDP, up from 5% just six years ago, it seems to me like it is discounting a lot of panic (the euro will fall apart, the West will inflate away all of its debt, the US will devolve into a second-rate power, etc. etc.).

They Are Scared Witless..

2011-08-15T04:05:00.001-04:00

In this post's title "they" are speculators/investors (are there any true investors left in this world, I wonder?) and "witless" means exactly that: they have taken leave of their wits (assuming they had any to begin with, of course).

Proof? The following charts, showing:

(a) The price of gold soaring to new highs, apparently discounting a heavy bout of inflation in the future and,

(b) The yield on 10-year US Treasury bonds crashing to near new lows, apparently discounting future deflation.

Gold Flying High

10-Year Yields Collapsing

It stands to reason that this situation is untenable and can only occur when speculators are very, very scared, running about like chickens with their heads cut off. I am a long-term investor myself, a natural-born contrarian bent on spotting exactly such nonsensical divergences.

Markets always provide tremendous opportunities to level-headed contrarians at two nexus points: bubble bullishness and panic. Characteristic to both is the absence of common sense, observable and easily calculated by simple arithmetic (ratios are as far as you have to go).

For example, the ratio of gold price to 10-year yields stands now at 776 (it went as high a 850 a couple of days ago). Just three years ago it was at 210...

The witless in search of "safe" havens, indeed...

As The World Burns

2011-08-05T04:32:00.001-04:00

Well, now it's official: The Debt Crisis is global. But what lies at the heart of it? What are the economic fundamentals which have created it?

In a word, "China". Oh, I don't mean that China as a nation is at fault, that it is to be blamed for the profligacy of Western consumers and their politicians' astonishing inability to lead, predict or - at least - to react properly. No, I use "China" as a label for our present borrow-spend-inflate assets economic paradigm

In the last couple of decades we in the West have moved a huge portion of our manufacturing to China and become junkies of debt-financed ultra-cheap goods. Said finance provided by China, of course. It doesn't take a PhD in economics to spot the imbalance, of course. As I have said many times before, the Debt Crisis is not the disease but a symptom, albeit a lethal one.

What is the proper remedy? Nothing less than a global shift in the economic paradigm: we urgently need to move away from global consumerism to local "investism" (to coin a word). Invest in what? you ask. Green energy, mass transport, environmental amelioration, recycling, responsible resource management - and these are just a few items that have the very real potential to create a boom in local manufacturing and skilled jobs for a very long time, measured in decades.

Think of it this way: what is more important for our own present and our kids' future? A third (and fourth and fifth) pair of cheap sneakers, or a new solar power plant? Another V8 4x4 monster, or a new electric railway? A fossil-fuel economy that resembles a roller-coaster nightmare, or an increasingly feasible electric utopia?

It's time to wake up from the bad dream and get to work building our very own Utopia.

PS For my European friends: Do you seriously think you can have a common monetary policy (the euro) without a common fiscal policy? Do you, really?

L'Affaire Strauss-Kahn

2011-07-01T03:38:00.000-04:00

Il n'y a aucune coincidence dans la (haute) finance (pronounce in French for maximum rhyming effect).

Well, well, well... the prosecution is furiously back-pedalling on its charges against Mr. Strauss-Kahn. It seems the chambermaid is not exactly the unspoilt lily of veracity she claimed to be. As the Reuters article in the link puts it: "Case against Strauss-Kahn near collapse".

Being in the field for over a quarter century I have learned, often the hard way, that weird coincidences simply do not exist in finance. If it seems too good (or too bad) to be true, it is safe to bet that it's not true.

So, let's make no mistake here: there were way too many and powerful interested parties that wanted Mr. Strauss-Kahn out of the way. Who? In Latin, we ask: qui bono? (who stands to benefit?).

I'm not going to bother with the obvious French presidential race political stuff. Instead, I think it was NOT a coincidence that the European debt crisis got much worse right after Mr. Strauss-Kahn, a confirmed euro-booster, got arrested and paraded publicly in manacles.

I'll go back to watching summer sunsets, now. But I think the summer is about to get much, much hotter from here on.

A Blast From The Past

2011-05-16T09:46:00.000-04:00

I have been re-reading Gustave LeBon's The Crowd, the 1895 classic on the psychology of herd ("crowd") behavior. The French social psychologist was the first to scientifically and methodically study crowd behavior outside the criminal classes.

Here are a few bon mots:

Crowds amass mediocrity, not intelligence.
Compared to individual persons, crowds are always intellectually deficient.
Crowds cannot help but exhibit excessive credulity.
When in a crowd, an individual's faculties of observation and critical ability vanish.
Events witnessed by the largest number of people must be questioned most of all.

I am sad to say that Hitler, Mussolini and Bernays (Freud's nephew) were fans of this book, putting it to ungodly and unhealthy use (Bernays convinced women to smoke). Ah... propaganda, thy name is Herd.

And what do financial markets have to do with crowd behavior? Well, actually, the proper question is: when do financial markets not have anything to do with crowd behavior?

The Land of "Miracles"

2011-05-03T10:41:00.000-04:00

Greece... land of Pythagoras, Plato, Pericles - and more platitudes than you can shake a stick at.

Nevertheless, here's one more from a Greek bank professional: Greece is the land of miracles. (I'm certain he didn't quite mean it as a compliment).

To wit, ANYTHING can happen there. Here's a handy comparison from recent history.

First, a current chart of the 5-year CDS (credit default swap) on Greek government bonds (click to enlarge).

Greek CDS

Second, a chart of what happened in the Greek stockmarket some 10 years ago.

Greek Share Prices 1997-1999

Get my point, via chart comparison? The place is basically looney-tunes and CANNOT be analyzed or predicted in any rational, by-the-numbers method. For clues, best dust off the psychotherapy manuals and be prepared for excess, negative AND positive.

Third, here's how the share bubble burst after the year 2000. The "miracle" of 1999 turned into dust shortly thereafter.

Now, given the excess of emotional swings apparent above, I wonder what may happen to Greek CDS prices in the not-so-distant future?

You Call This Global Leadership?

2011-04-08T06:41:00.001-04:00

The US government is about to be shut down in the next 24 hours over the federal budget impasse. Here are the only numbers you need:

Federal spending is approx. $3.7 trillion, the deficit this year alone is projected at $1.4 trillion - and the politicians are squabbling over spending cuts amounting to $33-40 billion; that's 1% of spending and 2.9% of the deficit. You gotta be joking, right?

Obviously they are not, so I must conclude that their heads are so deep into the sand that they are in danger of being swallowed whole into their self-made political sand-trap. If they call this leadership on a global scale then I suggest we call in the Greeks...

You Call This Global Leadership?

It's Greek To Me

2011-04-06T06:26:00.000-04:00

The amount of hot air emanating from Washington DC has increased exponentially as politicians are arguing about the size of next year's budget deficit, but no matter what they decide it will be, in a word, monstrous.

To illustrate just how bad things are in the good ol' USA fiscally-wise, here's a helpful comparison:

Not fair to compare the US to Greece, you say? Correct, because the figure for Greece is for the general government, i.e. it includes all local and municipal budgets, whereas for the US it involves the federal government only.

So, yes, it's Greek to me...

How Green Was My Valley

2011-03-29T06:13:00.000-04:00

The world is changing right in front of our eyes and politics are - finally - starting to reflect this.

In last Sunday's elections, voters in the German state of Baden-Wurttemberg elected a Green Party prime minister (governor) for the first time in the country's history, trouncing Mrs. Merkel's conservative CDU and significantly altering the wider political balance for the entire nation. It should be noted that the state of Baden-Wurttemberg was a conservative party stronghold for 58 years in a row. The nuclear disaster in Japan doubtless had something to do with it, but I believe it was going to happen anyway.

Germany is way ahead of every other major nation in shifting electricity generation to renewable/green sources. In the past 25 years the entire increase in production has come from such sources (see chart below - click to enlarge).

Chart: IEA

Germany - Going Green

So, yes, Germany's "valley" is very green, indeed. Are the rest of us going to do something about it, or are we going to stay stuck in the past and suffer the consequences?

Oh, and if you're wondering: How Green Was My Valley is a classic film from 1941 about a Welsh coal -mining town. From IMDb: "This story of a Welsh valley's turn-of-the-century descent from pristine paradise to despoiled coal mining region, is told in flashback form by Huw Morgan, an old man who has decided to leave the valley forever."

The World's Banzai! Moment

2011-03-17T11:11:00.124-04:00

Banzai!: A traditional Japanese exclamation meaning "ten thousand years" (somewhat equivalent to our own "hooray!"). Often used in the context of a banzai attack, a last ditch desperate charge.

Centuries from now when historians examine our time, I imagine they will conclude it took an earthquake, a tsunami and a nuclear catastrophe for people to finally snap out of their Permagrowth lethargy - the one induced by rampant consumerism, excess debt and the unchecked use of poisonous "black" fossil and nuclear energy. Japan may be featured as villain or angel, depending on which path it chooses to take after the current emergency is over.

Will it go green and reach for Sustainability, or will it stay black and remain blinded by Permagrowth?

First, let's look at where the country stands right now:

Japan is one of the world's blackest nations energy-wise. In 2008 97% of all energy supplied came from coal, oil, gas and nuclear sources (see chart below, click to enlarge).

Chart: IEA

Japan: A Black-Energy Nation

Japan is one of the world's most highly indebted economies. In mid-2009 total debt stood at 472% of GDP, up from 245% in 1980 (see chart below, clock to enlarge). The most rapid escalation came after 1990 as the government started borrowing heavily in an attempt to keep the Japanese Permagrowth model running. It failed, and the economy has been stagnant for years, no matter how many bridges to nowhere it built. Importantly, most of this debt is internal and serviced from local savings, preventing outright collapse. However, financing reconstruction after the earthquake-tsunami-nuclear disaster is another matter altogether.

Data: McKinsey Global Institute

Japan: A Country Awash In Debt

Right now, then, Japan is certainly a Permagrowth "villain". But catastrophic events can often lead to radical change and - who knows? - in the aftermath Japan may well become a Sustainability "angel". It already exhibits some sustainable-like elements: Japanese society is stable and technologically sophisticated, with zero population growth and high living standards.

When seen from the perspective of Permagrowth Japan is perceived as weak (e.g. no GDP growth); but from the Sustainability viewpoint a weakness may very well be an advantage (e.g. zero population growth).

I sincerely hope that the Japanese people, justly famous for their stoicism and perseverance in the face of serious trouble, cry "banzai!" and choose Sustainability for their reconstruction model. If they do and succeed (which they will), it will be the entire world's Banzai Moment.

Assuming this happens, then renewable energy will be a big winner. I recently bought some shares in FAN, an exchange traded fund that tracks the ISE Global Wind Energy Index. Given its recent bottom-scratching performance (see chart below, click to enlarge) I think it's a decent candidate for fans (pun smile) of long-term buy-low, sell-high strategies.

First Trust Global Wind Energy ETF

Yet Another Three Sigma Event

2011-03-14T09:26:00.002-04:00

Not all natural catastrophes are as "natural" as they appear: the mega earthquake and tsunami in Japan may be as natural as they come, but the ongoing nuclear disaster is anything but..

What has apparently happened is that, while reactors were properly and safely shut down after the quake, the systems required to cool down their 6% residual fission had to operate on power supplied by diesel generators which, however, were flooded by the tsunami and immediately knocked-out. Oh yeah, they were NOT located on high ground, the plant designers relying instead on a seawall to protect them (ask any ship architect were emergency generators must be placed).

Then again, such monster 10 meter tsunami waves were not supposed to happen, right..? Now, does this ring the Nuclear Hubris Bell, or what?

(If you do anything in the aftermath of this, I insist it is to read and apply Nicholas Taleb's extremely appropriately titled The Black Swan: The Impact of the Highly Improbable: With a new section: "On Robustness and Fragility")

Or, does it remind us of that other three-sigma event that was also never supposed to happen? You know what I'm talking about: the sudden collapse of investment-grade alphabet-soup bonds which were transmuted from toxic waste into "ultra-safe" investments.

Before the global financial crisis hit, I often compared the debt and derivatives situation to a chemical (or nuclear) reaction approaching a "critical" point. Such a reaction may proceed for quite some time without any adverse effects, but if left unchecked it can create an explosion within a split second.

________________________________________________________________

A Graphic Representation of A Critical Reaction

High debt and nuclear power have something in common: they are inherently unstable, so no matter how "robust" you try to make their containment systems they can never be 100% safe. Furthermore, the adverse effects from three-sigma accidents involving them are obviously widespread and dangerous to the extreme.

So, why do we keep using them? Why do we still fuel our Permagrowth economy with Debt and Nukes, instead of earned income and renewable energy? I shall leave the answer to others, but I firmly believe it to be a huge mistake.

Private Debt Comparison: USA v. Greece

2011-03-11T09:14:00.003-05:00

The "Greek Debt Crisis" is once again in the forefront since the EU leaders are meeting today and tomorrow - yet again - to figure out how to deal with it and the larger issue of debt and competitiveness inequalities across Europe. The discussion on debt, however, focuses almost exclusively on government borrowing - a mistake, in my opinion.

Here's a chart that compares Greek and US private sector debt (households and corporations) as a percentage of GDP (it excludes financial sector debt). Note how fast Greek private debt rose once the country entered the eurozone: it literally exploded from 44% of GDP at the end of 2000 to 111% at the end of last year. Membership to the club had its (extremely dubious) privileges.

Greek Private Sector Debt Zoomed (excludes financial sector debt)

This debt explosion fueled private consumption and, thus, GDP growth. Does it sound familiar? Of course it does; in the last decade Greece and the US went "shopping" for their economic models at the exact same bargain store: Debts 'R Us.

For another (admittedly more questionable) comparison, in the next chart I include debt of the financial sector. It changes our perspective, doesn't it?

This Chart Includes Financial Sector Debt

Including financial sector debt leads to double counting for some of the debt (e.g. securitized mortgage loans) and distorts the picture considerably. However, it does provide a valid warning that has to do with inter-connectivity, counter-party risk and financial globalization (think Bear Stearns, Lehman and falling dominoes).

Let's hope that Europe's leading lights (smile) figure out a solution...

Update: After pulling an all-nighter, EU leaders agreed to extend the duration and lower interest rates on Greek loans. More intriguingly, they also agreed to allow the financial stability fund (EFSF) to purchase government bonds in the primary bond market, i.e. when new bonds are issued.

This appears a pretty good compromise between outright purchases in the secondary market and no purchases at all. Properly implemented, it will:

(a) Provide real incentive for over-indebted countries to put their financial houses in order fast so they can go back to borrowing from the free market, benefiting from the underlying purchase support.
(b) Convince markets there is real commitment to help eurozone countries when and if needed, but keeps the pressure on governments to reform their economies.

In other words, it's a workable combination of carrot and stick - the latter being absolutely necessary to appease Mrs. Merkel's angry German voters who objected to outright bond purchases in the secondary market, viewing them as bailouts for profligate Greeks.

Deja Vu, All Over Again

2011-02-23T04:59:00.001-05:00

The current situation in the Arab world reminds me strongly of the end of the Soviet Union and its Warsaw Pact allies in the early 1990's. Though the Arabs do not have a centrally-controlled power structure like that of the late USSR, they nevertheless possess many more similarities, chief among them a reliance on a single core activity (oil vs. military), authoritarian/dictatorial regimes and enormous social inequalities.

It looks as if the Arab "Berlin Wall" is crumbling right in front of our very own eyes. What it means for our hydrocarbon energy regime is impossible to predict. It could be that radicals take over and attempt to hold the world hostage to much pricier oil. Or, it could be that they pump all-out to satisfy popular demands for social goods and services, driving prices much lower. No one really knows.

What is crystal clear, however, is that we urgently need to create to our own renewable, locally produced, stable energy sources and finally become independent of the Arab "street", as well as the Arab "sheiks".

Real Reason For Real Optimism

2011-02-16T06:36:00.001-05:00

I'm stricken with a bad case of blog-writer's block. It's not the first time, so I know how to get by until the spirit grabs me once more: recommend a book or two or, as is the case today, send readers to an article I find interesting.

Soaking Up the Sun to Squeeze Bills to Zero, appearing in today's NY Times, made me feel happy, optimistic and vindicated for my long-held belief that it is absolutely achievable to transition to a Sustainable Economy regime powered largely by renewable energy.

The article describes how the new 222,000 sq. ft. Research Support Facility of the National Renewable Energy Lab (Dept. of Energy) in Golden, Colorado uses a net zero amount of energy via widely available and cost-effective technologies.

But did it cost the taxpayer an arm and a leg to construct this super-efficient office building? From the article we learn that: "Ultimately, construction costs were brought in at only $259 a square foot, nearly $77 below the average cost of a new super-efficient commercial office building, according to figures from Haselden Construction, the builder."

I'll say it once again... It CAN BE DONE. Please read the article.

The RSF in Golden, Colorado

Designed to Provide Maximum Day-Lighting Throughout the Building

It's Not Game Over, But We're In Overtime

2011-01-31T04:21:00.000-05:00

Commenting on the previous post on QE a reader asked (hat tip: shtove): "Are you saying the Fed has managed this quite precisely - replacing lost credit with its own version, only so much and no more?"

This is my answer:

It's not only the Fed that is "managing" this. In fact, it's mostly the Treasury, the Chinese and the Oil Arabs who are 100% complicit in global monetary policy, even as they appear to be "mad" at the US. The Arabs are a slightly different case than the Chinese because they are one-item, one-export economies and ruled by dictatorships, but they are not too different.

The enormous bump in current federal budget deficits is a textbook Keynesian response to the burst bubble; it is obviously financed by issuing Treasury bonds - and who buys them? Essentially, those with surpluses, i.e. the Chinese and the oil exporters. If they stop buying, the US economy will tank and their own exports will come crashing down. Simple stuff (which also explains to a great degree why Sustainability and Renewable Energy are anathema to The Establishment).

But the bond buyers ARE getting antsy. It's always caveat emptor, after all. Keep this firmly in mind, because - among other things - it explains why the Chinese President got the Full Monty treatment from Obama (e.g. State Dinner at the White House), when Bush II had given him only a working lunch a few years back (what, bagels, cream cheese and Snapple?). The Chinese Emperors demanded deep kowtows and memories of Empires Past are once again very much alive. (But, we should remember that the Japanese had become similarly insufferable twenty-some years ago and look what good it did them..).

Anyway, to the degree that it is able the Federal Reserve is also buying Treasurys by artificially inflating its balance sheet (i.e. by "printing" money = QE1, QE2, etc.). Obviously, it can't buy all the extra Treasurys with "funny money" because then we will get hyperinflation and the dollar will tumble uncontrollably. It is, therefore, imperative that the Sino-Arabs go on buying lots and lots of Treasurys.

Foreign Purchases of Treasury, Agency and Corporate Bonds

This Is What Happened After 2000...

The financial elites in all countries involved are smart people; far from being naive simpletons, they are 100% aware of what the game is all about. But they have to play by the rules and they have to listen to popular sentiment (or appear to do so). It is crucial, therefore, that popular sentiment be shaped accordingly. Thus, the propaganda machine has gone into high gear, with the Anglo-American financial and media communities extremely hard at work bad-mouthing the euro. The vital purpose is to avoid serious "competition" for bond purchases and keep the money flowing into Treasurys (and gilts, to a much smaller extent). Inundate the crowd with breathless messages about the Euro Crisis (in capitals, of course) and the job is half done.

So, let's get this straight: there is no Euro Crisis in FACT, other than the one that is being whipped up by the likes of FT, Bloomberg, Reuters, WSJ, Roubini, Rogers and The Economist. As a reader aptly said, "Greece is a sideshow". It's smoke, pure and simple, to hide the wreck of the Anglo-American balance sheets.

That's why lately I've been focusing on debunking this Euro Crisis myth. Because once that's understood to be nonsense, the REAL debt crisis becomes quite starkly clear:

THE US AND THE UK ARE FOR ALL PRACTICAL PURPOSES BANKRUPT

Continuing bond purchases by the Chinese and Arabs are masking reality, but when - not if - they stop buying, it's GAME OVER. I don't know when this will be; like all empires in decline, the ultimate bust may take a long time. But we are in overtime right now and the "players" are still using the same old failed game plan.

I'll leave it at that, but in closing I wish to recommend a book that sheds plenty of light on how empires crumble from within. In this case it's about the Soviet Union, but the lessons and implied warnings are universally applicable.

The Dead Hand: The Untold Story of the Cold War Arms Race and Its Dangerous Legacy deals with the Reagan-Bush/Gorbachev-Yeltsin era and reads almost like a novel.

2011-01-28T07:23:00.001-05:00

In answering a reader's question about the relationship between quantitative easing (QE) and food price inflation (hat tip: Crito) I mentioned that QE may not, in fact, increase money supply. This is because it is not known how much of the liquidity injected by the Fed is additive to the system, or if it is just filling the vacuum left by debt defaults.

Here are some data on total credit expansion from the Fed's latest Z1 report (click to enlarge).

Zero Total Credit Expansion in 2009-10

Credit expansion in the private sector collapsed after 2008 with the financial sector leading the way down by contracting over 15% in two years. The federal government took over as its borrowing zoomed 76% after 2007. Net-net, however, total credit outstanding has been flat in 2009 and 2010, at least until the end of the third quarter (latest data available).

It seems to me, therefore, that QE1 and QE2 have merely substituted for some of the "money" that has been destroyed via debt defaults and should not in theory create overall inflationary pressures. But markets are mostly psychological manifestations and not theoretical structures; if punters believe new money is pouring out of the printing presses, then they bet accordingly and commodities - to name but one - rise in price. That's what I call Quantum Finance or, Perception Creates Reality.

Looking at things from a longer-term perspective it is obvious that total debt (i.e. money) and prices should move together: if there is more money chasing goods and services prices will inevitably rise. Commodity prices have tripled in the last ten years (see chart below - click to enlarge).

Reuters-CRB Commodity Price Index

The US dollar is the world's primary reserve currency used to price and trade everything from crude oil and gold to wheat and pork bellies, so it makes sense to look at how much of that "stuff" is around. Total debt in the U.S. has more than doubled in the last 10 years.

Swift Action Required

2011-01-22T03:58:00.003-05:00

This story appeared in the NY Times a couple of days ago, reporting on the possibility of buy-backs for deeply discounted Greek Government Bonds (GGBs) in the secondary market by the European financial stability fund (EFSF). The particular story - there are many more like it in the financial press - was brought to my attention by Okie (hat tip), a longtime reader who wondered if I had something to do with it.

Well, no and yes. No, I didn't write the story nor did I campaign actively from the "inside" for implementation of the buy-backs. But, yes, I believe I was the first one to come up with the idea; it was published in this blog on November 23 under the title How To Restructure PIGS Debt - A Modest Proposal. Please read it if you feel like it.

Another reader wondered if I had a priori knowledge of these developments, i.e. if I possessed inside information. Absolutely not - but I do have extensive knowledge and practical experience involving sovereign debt markets and derivatives, allowing me to recognize opportunity when it arises. Couple that with a solid dose of common sense and, voila, A Modest Proposal.

No one, however, commented on the (perhaps not so obvious) reference to Jonathan Swift contained in the original post's title. A Modest Proposal was published anonymously in 1729 by the renowned Anglo-Irish satirist and in it he proposed that impoverished Irish farmers should fatten up their children and sell them as meat to the well-off gentlemen and ladies of the land. His essay went to great detail, including statistics, economic benefit calculations, quotations from (fictional) presumed authorities - even recipes!

My post was not meant to be satirical in the least, of course. However, the chance to allude to rich Europeans eating their own poor children as a solution, instead of firmly helping them overcome their difficulties, was too good to pass up. And make no mistake, there were and still are many addle-brained idiots (I use the word in its classical meaning) in Europe who see the debt issue from a destructive self-centered perspective.

Nevertheless, the market is starting to smell that a more comprehensive solution is in the works. Though still at lofty levels compared to a year ago, prices for credit default swaps on GGBs have come down considerably in the past week (see chart below, click to enlarge).

5-Year CDS On Greek Government Debt

My prediction for the European debt crisis is that it will involve a long process of adjustment and real economic convergence amongst the partner nations. Unlike the 1990's, when countries who wished to enter the eurozone focused on meeting numerical targets laid down by the Maastricht Treaty, Europe today has no alternative but to become more cohesive, more integrated, more co-equal, to use a fashionable term, itself alluding to the pigs of another famous essay.

It won't be easy, it won't be smooth, it won't be pretty. But it will happen and it will succeed.

Sophomoric Opus

2011-01-14T04:06:00.005-05:00

Sophomore: A person who is at the same time wise and foolish, perhaps because he lacks experience. From the Greek sophos (wise) and moros (foolish).

----------------------

When it comes to markets, I am a confirmed contrarian. That is, I constantly look for signs of excess and act accordingly. What signs? It could be anything, really, but I usually focus on human behavior and psychology, e.g. doom, gloom, exuberance and frivolity. What matters is the contrast between reality and unsustainable expectations - positive or negative. Like radioactivity, the best type of contrarian evidence is cumulative, i.e. it appears in additive layers, from many sources and in many varieties.

Here's one such bit: The Imminent Crisis: Greek Debt and the Collapse of the European Monetary Union is a short book (140 pages) by Grant Wonders. Who is he? A Harvard sophomore studying economics and archaeology. It is published by GW Publishing, the initials obviously from Mr. Wonders name.

Here's another:Bust: Greece, the Euro and the Sovereign Debt Crisis. On the face of it, this work must be a bit more serious since it weighs in at 288 pages and is written by Matthew Lynn, an occasional Bloomberg columnist. At least he's not a sophomore. But, writing as Matt Lynn, he also turns out a serial military action thrillers with titles such as Death Force, Shadow Force, Fire Force, etc. The blurbs claim that "You can taste the dust and smell the blood" . You get the type..

And yet another, this one in song form.

So, there you have it. And Greek long bonds are trading at around 55 cents on the euro.

I can taste the fear, smell the money and wouldn't short Greek securities, stocks or bonds, not even on a Sunday.

Hell No, They Won't Go

2011-01-13T10:48:00.001-05:00

Just like the premature announcement of Mark Twain's passing into the hereafter, breathless predictions of the Euro's death are greatly exaggerated. In sharp contrast to this swirling maelstrom of half-truths, targeted innuendos and outright bull**, this well-reasoned and comprehensive analysis of the situation by Paul Krugman stands out and is well worth reading.

I do disagree with a few of Mr. Krugman's points, however.

Like nearly every non-European, he perceives the euro mostly in technical/monetarist terms, instead of historical/socio-economic ones. It's like saying the U.S. Declaration of Independence was put together by a bunch of frustrated colonists solely for the purpose of avoiding King George's high taxes. He's definitely not alone in grossly underestimating the will of Europeans to integrate their separate nations into a cohesive peaceful Europe, but as a Nobel laureate maybe he should know better.
He mentions American economist Irving Fisher from almost 80 years ago, who claimed that economic crises deepen when incomes fall but debt remains unchanged. That was and remains true in theory, but in the case of the eurozone today's secondary bond markets can be adapted as debt reduction mechanisms. For example, with Greek government bonds trading at 50 or 60 cents on the euro, a pan-European entity (e.g. the ECB) can quickly step in, scoop them up and refinance the purchased amounts at cost. This is now being seriously considered by European leaders (but you heard it here first, eh?).
He draws a parallel with Argentina's default and the peso's 1-to-1 peg to the U.S. dollar. Crucially, however, the euro is not a peg but a national and international reserve currency. No matter how "hard" and "irrevocable", Argentina's peg involved pesos, a national currency that was vulnerable to psychological pressure and loss of confidence. Furthermore, unlike the eurozone, Argentina's economy was not at all integrated with that of the U.S. For example, trade between Argentina and U.S. in 2007 (exports plus imports) amounted to a mere 9.6% of Argentina's total foreign trade. Compare this to Greece, where 56% of its total foreign trade is with other EU nations.

My take on the "European Crisis" is that it amounts to more than a storm in a teacup, but much less than a perfect storm capable of sinking the euro or the EU itself. It is United Europe's first real test, a challenge from which it will come through stronger and more confident.

Despite the currently deafening cacophony of opportunistic sycophants, Europeans will soon start doing a bit of their own yelling: "Hell No, We Won't Go" (..quietly to the dustbin of history).

CDS: Hedge Or Hog?

2011-01-09T05:09:00.001-05:00

Are credit default swaps (CDS) legitimate hedging tools or just another way to bet the ponies?

I was there at the beginning, so I know that CDSs were originally designed to hedge or reduce credit exposure. It was a highly specialized, custom-made and low-volume business stuck in quiet corners of trading floors, away from the glamorous hot spots of foreign exchange, money markets, derivatives and bond trading. With trade documentation going back and forth, individual trades frequently took days to complete.

It was slow going for several years - and then everything changed. From a very modest $630 billion notional outstanding in the first half of 2001, CDSs exploded a hundredfold to $62 trillion at the end of 2007 (see chart below).

Data: ISDA

CDS Amounts Exploded 100-Fold Within Six Years

This mad rush into CDS was not caused by some pent-up craving to hedge credit risk - quite the reverse, in fact. Instead of seeking to reduce credit risk on existing bond portfolios, the new players who came into the market after 2004-05 used CDS as riskier and more volatile alternatives to straight bonds, viewing them as juicy income streams. That's when CDSs ceased to be "hedges" and became "hogs".

This became very obvious with the issuance of synthetic and hybrid CDOs, types of second-order derivative products made up of a mixture of various CDSs, that acted like bonds on "speed". In just three years between 2005-2007 a total of $160 billion of purely synthetic CDOs (e.g. CPDOs) were issued globally, while cash flow and hybrid CDO issuance reached nearly another $1 trillion. (All Data: SIFMA).

Pointedly, a stunning 90% of all CDO issuance in this period was done for arbitrage purposes, i.e. to profit from the spread between the expected yield of the underlying CDO assets (e.g. CDSs) and the financing costs of the CDO tranches themselves. This incredible percentage, more than anything else, reveals the true purpose of derivative finance: leveraged speculation. It reveals that hedging - the usual excuse paraded out when credit derivatives come under criticism - was very far from the minds of those who dealt in them, since only 10% of the issues were "balance sheet" deals done to legitimately remove assets or their risk from originators' books.

It must be pointed out that CDS were not the only derivatives that went ballistic in that time. Total derivatives outstanding reached a face value of $700 trillion in 2008 (see chart below).

Anyway, it takes two to do the CDS tango so there's an obvious question begging to be asked: Okay, greedy speculators and/or foolish pension fund managers knowingly or unknowingly sold credit insurance before the crisis on the cheap (see chart below) and by the boatload ..... But who bought?

Chart: BIS

Who were so prescient and so smart as to keep buying the trillions of CDS that fools were literally giving away before the crisis hit? Well, they didn't save AIG from collapsing into its CDS crater for the benefit of mom and pop policy-holders, did they?

The trouble with the property and casualty insurance business (and CDS are essentially P&C insurance products, no matter what bank traders say) is that it is very, very cyclical. Competition increases and premiums charged collapse when claims are low, but then a major disaster occurs and everyone scrambles to raise rates. Sound familiar?

Right now, 9 out of the top 12 entities in CDS by notional amount outstanding are sovereign nations like Italy, Brazil, Spain and - of course - Greece (see chart below, click to enlarge). Yes, it does make some sense as things stand right now with the CDS market, because nations are the largest debt issuers. But how much sense does it make to allow punters to go on betting on sovereign defaults, when it is the taxpayers who bail out the punters? This is exactly like "Heads I win, tails you lose".

Data: DTCC

When you think about it, it's a paranoid/schizophrenic situation: paranoid CDS players have one personality that bets furiously against the credit of nations, driving up borrowing costs and forcing taxpayers to foot the increased bill. Their other personality fervently believes that nations and taxpayers are the ultimate guarantors of the survival and smooth functioning of the financial system. Can they have it both ways? Well, sure - but only for as long as the sovereign CDS bubble lasts. Because like any other bubble this too shall burst, and spectacularly so.

Let me put it another way: how long can a dog keep biting the hand that feeds it?

Mythbusters

2011-01-03T05:06:00.002-05:00

I'm a facts- and data- driven person, as one could easily surmise from my background. So, when someone throws out comments like "lazy Greeks" I go looking for the numbers.

Surprise, surprise... (click to enlarge chart).

Data: OECD

Greeks Are The Hardest Workers In The World

According to the OECD Greeks work 2,119 hours per year - that's 25% more than Slovaks (the commenter referred above said he is from the Slovak Republic) and a whopping 52% more than Germans.

Looks like the populist myth of Greeks lazing and dancing by the seaside, drinking ouzo and munching on souvlaki is solidly busted.

Quotes For A Future Decade

2010-12-31T12:08:00.000-05:00

The best way to predict the future is to create it. Peter Drucker

I do not want to foresee the future. I am concerned with taking care of the present. God has given me no control over the moment following. Mahatma Gandhi

Do not dwell in the past, do not dream of the future, concentrate the mind on the present moment. Buddha

The future ain't what it used to be. Yogi Berra

Every saint has a past and every sinner has a future. Oscar Wilde

Real generosity toward the future lies in giving all to the present. Albert Camus

Never let the future disturb you. You will meet it, if you have to, with the same weapons of reason which today arm you against the present. Marcus Aurelius
The future enters into us, in order to transform itself in us, long before it happens. Rainer Maria Rilke

There is no prophet of the future for mortal men. Sophocles

Cease to inquire what the future has in store, and take as a gift whatever the day brings forth. Horace

God doesn't play dice. Albert Einstein

,,, but he sure as hell loads them. Hellasious

Happy New Year!!

Greece Got Run Over By a Reindeer

2010-12-24T07:45:00.003-05:00

What gives with Greece? If we look at only one, narrow, set of the statistics, i.e. government debt and official GDP figures, and compare them with other nations, then by all means Greece is essentially bankrupt - just as so many fear-mongering "analysts" claim.

But... Disraeli's saying "lies, damned lies and statistics" is always a good piece of advice. Even if he actually never said it himself.

So what should we look at? Two facts:

Greece has one of the lowest total debt to GDP ratios amongst OECD nations. Yes, that's right, lowest; because even though government debt is very high at 127% of GDP (end of 2009 and going higher, probably to 140% by the end of 2012) private debt (i.e. corporate plus household) comes to only 108% of GDP, making for a total debt to GDP ratio of only 235%. That's lower than Switzerland (313%), Canada (259%) or, gasp!, ever-so-self-righteous Germany itself (285%).
Greece has a very large, but very real, "shadow" economy due to widespread tax-evasion and corruption. The IMF estimates it at 27% of GDP, by far the highest of any OECD nation (average is estimated at 11%). This means that officially reported Greek debt/GDP ratios are grossly overstated.

Below is a table I constructed based on data from McKinsey for total debt (2009) and the IMF for the shadow economy. The adjusted figures include the shadow economy in the total debt to GDP ratio.

See anything grossly out of line?

One has to wonder how "the market" operates sometimes, eh? Looks like Greece got run over by a reindeer this Christmas. On purpose..?

It's The Politics, Stupid!

2010-12-23T07:43:00.002-05:00

Everyone's taking potshots at the eurozone these days and given the number and clumsiness of European "leaders" running around in the open it's like a turkey shoot down at the country fair. Even those who couldn't hit a barn at 100 ft. can go home feeling like sharpshooters.

Nevertheless, analysts from outside Europe's "hard core" have it all wrong. They presume the eurozone to be all about finance and monetary policy and, having made this fundamental mistake, conclude that the euro is untenable, no more than a rickety structure about to crash as weak-link peripheral countries like Greece and Ireland (or even - perhaps - Spain ) buckle under the strain of their large debts.

However, the establishment of the European Union over fifty years ago and the adoption of a common currency are not guided by money and economics, but a common vision for peace and prosperity after centuries and centuries of constant, bloody war. Since 1300 AD (at least) there has never been a period of 50 consecutive years of peace in Europe - except now (excluding the "police action" in former Yugoslavia). That alone says a lot.

There is no way that Europeans and their leaders are going to let the euro and the EU collapse; there is simply way too much at stake. Does anyone seriously think the Germans - to name only one nation - want the EU to fall apart? The Europeans who arguably suffered the most as they lost not one, but two world wars? C'mon..

To paraphrase Bill Clinton, it's the politics, stupid!

So, here's my wish for Christmas 2010 : Peace On Earth.

Have a wonderful holiday, all.

The Stupidest Cut Of All

2010-12-10T00:39:00.005-05:00

Unlike the French, the British are most definitely not a nation of active protesters and rioters. So when they take to the streets, smash shop windows, throw chunks of steel-reinforced concrete, set fires and a ttack Prince Charles's Rolls Royce (a smashing counterpoint to austerity, old boy) you know something is terribly wrong.

All this is caused by the conservative government's decision to cut university funding by an astonishing 80%, passing the bill on to students and resulting in doubling and tripling of tuition fees. Since most students can't afford such a massive hike, they will end up with - what else - taking up loans of up to $63,000 for three years of study (the normal course in a UK college).

I won't elaborate much on why slashing education spending is the stupidest cut of all because I consider it to be self-evident to anyone who can fog the mirror and count past ten without the aid of his fingers.

But I will say this: we have all of us in the West rolled up our manufacturing and unceremoniously packed it off to China (why else do you think China's energy use soared 100% in a mere five years?). Instead, we were supposed to become post-modern vibrant economies based on technology, design, know-how, smarts; in a word: education.

Well, Mr. Prime Minister Cameron, to quote from one of your famous countrymen, Goodbye To All That. Robert Graves was educated in Oxford just like you were, so I'm sure you understand my allusion to the needless slaughter of an entire generation of young men during WWI, and the figurative parallel with today.

The question is, will your children?

Energy: A Tale Of Four Nations

2010-12-08T05:15:00.001-05:00

I do an occasional post on Green/Low Carbon/Sustainable matters. The following four charts are quite illuminating, in my opinion (source: IEA). Click on each to enlarge.

Total primary energy supply by type

USA: The Dirty Carbo(n)ation

Germany: They're Trying

Denmark: They're Doing It Fast

I have saved the "best" one for last. What is going on in China is best described as scary as, well, Hell.

China: Heaven Help Them (And The Rest Of Us)

Final note: Notice how Danish total energy consumption remained essentially unchanged in almost 40 years, yet at the same time real GDP grew by 70%.

Chart: Statistics Denmark

What did Denmark do so right? Looking at its energy chart above we observe a tremendous shift away from oil and coal and into natural gas and renewables. That was no accident; and it resulted in, among other things, Vestas becoming the world's largest wind turbine company. It's very definitely possible to go green and prosper..

ECB Is Listening.. (?)

2010-12-02T04:10:00.001-05:00

It's been just a few days since my "Modest Proposal" post and the ECB is (finally) poised to intervene in the government bond market, looking to buy PIG(S?) debt in the secondary market. Excellent decision, if I may say so myself (insert false modesty). And to be really effective it should be a massive, knock-out blow. Hopefully ECB has some canny market operators in its staff who know how to act for maximum effect.

But as my proposal detailed, it's not enough for the ECB to just buy and hold existing government bonds on its books. The second step in this process, the exchange of old bonds for new ones at cost resulting in a reduction of debt by 30-50%, ought to follow immediately. The benefits to the national economies from a lower debt load and smaller interest payments would be very significant, making the market's reaction to the ECB operation even more pronounced.

Better yet, if the ECB exchanged the national bonds with Euro-bonds that are - almost certainly - coming, we would be talking about a Perfect Storm hitting the shorts.

Barbarians At The Gate

2010-11-30T04:38:00.000-05:00

As an old hand in the sovereign bond market I can understand - though in no way do I condone - "the market's" attacks on Greece and Ireland, even Portugal. They are small countries at Europe's economic periphery who borrowed more money from foreign lenders than was good for them and thus left themselves wide open to speculative attack.

Pygmies And Giants

But now things are getting serious: "the market" is attacking Spain, the world's eighth largest economy with a GDP of 1.1 trillion euro ($1.4 trillion). And "the virus" is spreading to Italy, Belgium and even to that paragon of financial probity, the most admired country in the world, Denmark. Yes, Denmark.

Take a look at the Credit Default Swaps (CDS) charts below (all from CMA).

Italian Sovereign CDS

Belgium Sovereign CDS

Denmark Sovereign CDS

(To make things clear: Denmark isn't even a member of the Eurozone! It's a full member of the E.U. but it still uses its own currency, the krona. It's debt/GDP ratio at 42% is tiny.)

So what is going on? Not to mince words, a concerted attack on the viability of the euro and thus on the very foundation of the EU itself. The existence of a common currency for the world's largest economic block is a threat to the US Dollar Hegemony, i.e. anathema for those who wish to prolong the world as we knew it, a modified construct from the Bretton Woods era.

The barbarians are at Europe's gate, threatening to tear down and pillage what took nearly three quarters of a century to construct. But it's not going to happen. Like Hannibal's elephants ante Rome's portas, the big financial institutions that are behind this ill-advised campaign are themselves vulnerable. They need massive amounts of cheap liquidity as fodder (only the Fed is supplying it at the moment) and risk-taking leveraged customers to piggy-back their positions (essentially, hedge funds).

They also rely on the complete absence of meaningful oversight and regulation for credit derivatives, an inexcusable condition for which European politicians are entirely to blame.

What is the solution? Starve the beasts.

Immediately withdraw all public pension funds from ALL alternative investment managers.
Prohibit any financial institution that has ANY activity in the EU from having ANY position in EU sovereign CDS. This includes banks, brokers, insurance companies, hedge funds, etc. that are either domiciled, have rep offices or raise funds in the EU. And when I say ANY activity in the EU I mean it: not even advertising would be allowed, no articles written by its employees, no interviews, nothing. NO-THING.

Bottom line: you want to play? OK let's play. But the rules of the game are going to be for the benefit of the people, not to attack the people. Because moral hazard should be, above all, moral.

Let's Try Some Perspective

2010-11-26T06:19:00.002-05:00

The drumbeat against the euro is increasing daily. It will fall apart, it will be limited to a hard core of Northern countries, it was a bad idea to begin with, you can't have uniform monetary policy without uniform fiscal policy, etc etc. The cacophony is so loud it is making common sense impossible to break through, particularly since "the free market" is screaming at the top of its lungs.

Let's try some perspective on that "free market", eh?

Gross Folly #1: How come the eurozone's financial center is... London?!! What this means in practical terms is that a scrum of bottom-line-is-everything bonus-hungry twenty-somethings hardly out of school are running the show. And to top it off, they and their country (the U.K.) are not even members of the eurozone. They don't use it, they don't believe in it and, if anything, they hate its guts. Literally. This like trusting a bunch of juvenile delinquents who amuse themselves with setting cats on fire to run the pet shelter.

Gross Folly #2: We let those same kids deal in sovereign bond CDS (credit default swaps) in an unlimited amount, without any regulation, in a completely opaque OTC market. They don't have to hedge their positions with the underlying sovereign bonds, they don't have to account for their actions to anyone but their immediate boss - who is also in line to make a huge bonus from their profit - and they don't give a damn if they push some poor country into bankruptcy and its people into starvation. Literally. This is like giving the nuclear missile launch keys to a bunch of manic-depressives and telling them they have to compete amongst themselves for their meds.

Gross Folly #3: We have allowed huge amounts of public and private pension monies to be managed by "alternative-investment" firms, e.g. hedge funds who are compensated on the outrageous 2/20 schedule. (The US Social Security is still OK, as it can only invest in Treasurys, but it came close to succumbing a few years ago.) This is like giving a bunch of convicted arsonists a tank-farm full of gasoline, asking them to put it to profitable use.

Gross Folly #4: The people of Europe have entrusted management of the whole shebang to politicians, their appointees and committees of clueless bureaucratic mandarins who wouldn't know the difference between a CDS and a CDO if it sat up and hit them in the face. (Again, the US is somewhat better at this since key government positions are frequently filled by experienced financiers.) This is like staffing Bedlam with a bunch of South Italian city managers, soviet-era Russian chefs from Vladivostock and over-sized German nurses named Helga. All overseen by the ghost of Joe McCarthy come back to life. No doctors. Oh, and only Wagner allowed in the rec room.

Have a nice weekend...

PS A friend in the business sent me this picture today. While I may not exactly agree with it, it is definitely indicative of sentiment towards Germany these days...

European Family Photo

How To Restructure PIGS Debt - A Modest Proposal

2010-11-23T15:38:00.002-05:00

With Ireland in political turmoil over its application to receive bailout funds, it is becoming obvious that we are getting caught between a rock and a hard place: on one side, markets (a euphemism for the unholy alliance of public pension money and the private money of the ultra-rich) are no longer willing to roll over the existing debt of the over-indebted, never mind increasing their exposure, at anything approaching reasonable interest rates. On the other, austerity programs attached to bailouts are causing high unemployment, pay and benefit cuts, tax increases and service cuts.

How long can this go on before things get seriously crushed, resulting in one or more massive unplanned defaults by sovereign borrowers, or massive social upheavals? Or both? It is my opinion that time is running out.

A solution must be found, and the sooner the better.

Let's lay some ground rules:

1. A solution should include structural reforms, where appropriate. For example, Greece must radically reform its public governance which is shot through with graft, corruption and ridiculous inefficiencies and raise the competitiveness of its economy so that it can produce goods and services attractive and attractively priced to the global marketplace. Ireland should re-think its corporate tax policy and start generating significant domestic savings to fund itself locally, instead of relying on foreign portfolio investors who can - and do - disappear at the first hint of trouble (Ireland sports an external debt of 1,000% of GDP).

2. A solution should not trigger a credit event for credit default swaps (CDS). Apart from not rewarding vulture speculators who bear significant onus for the current mess in sovereign bond markets, there is a systemic reason for avoiding a credit event. Before the explosion of the CDS market a default would result in well-defined losses: debt outstanding minus recoveries. For example, a "haircut" of 50% meant that lenders lost half their capital.

Today, however, there is at least $2.4 trillion outstanding in sovereign CDS, $2.2 trillion of which is sold by dealers, i.e. big global banks. If a credit event is triggered no one knows who will be pushed over the cliff by the tumbling dominoes, all happening in a matter of days (remember AIG?). Most positions are "offset" in dealers' books, of course, but no one gives a damn about offsetting when counterparty risk enters the equation in times of crisis (remember Lehman? or Bear? or Merrill? or Citi?). Here's what it is: under no circumstances is Goldman going to offset positions with Deutsche today if it thinks there's a risk of the latter filing for bankruptcy tomorrow, and vice versa.

CDS Prices For PIIGS

By allowing unrestricted CDS activity on sovereign debt we have increased credit exposure (more "debt" outstanding) and we also included more participants on the possible default list (the issuers of CDS). Oh, and if sovereign CDS comes second in amounts outstanding with $2.4 trillion, guess who is first? Oh yes, financial institutions, with $3.3 trillion. The systemic collapse that will follow a large sovereign default is too scary to contemplate.

3. A solution should provide for meaningful debt relief, i.e. result in the cancellation of 30% to 50% of debt outstanding and, soon thereafter, resumption of borrowing from free markets at reasonable rates.

How is this to be accomplished?

Step One: The European Central Bank (ECB) purchases in the open market sovereign bonds of the countries most at risk. Right now, this means Greece and probably Ireland. Depending on maturity, Greek Government Bonds (GGBs) are trading around 55 to 75 cents on the euro.

Step Two: ECB returns the bonds to the issuing country at cost and accepts as replacement new bonds of face amount equal to the ECB's cost. Maturity and interest rates remain the same.

Example: ECB buys 10 billion face amount of 30 year GGBs with a coupon of 4.60% at the current market price of 53, for a cost of 5.3 billion euro. It returns them to the Greek state and gets 5.3 billion face of new 30 year bonds bearing a coupon of 4.6%. Resulting debt reduction: 4.7 billion euro.

The operation is entirely voluntary for original bond holders, who don't have to sell. However, given that the ECB is going to be in the market all the time, bond dealers will have to sell, or raise their offers in order not to be lifted. Either way, the market will achieve a balance consisting of part debt reduction, part higher bond prices.

Benefits: debt reduction, bond market stabilization, CDS market coming back to earth, lower borrowing costs (eventually) for troubled countries, minimum political wrangling amongst EU nations, fast action.

Downsides:

Troubled countries may rely on ECB interventions and not implement needed structural reforms. That's why the ECB should act only in conjunction with requirements already in place, moving deliberately and stepwise as reforms are enacted.
Bond prices may jump inordinately under ECB's buying program. If this happens then ECB just doesn't buy, leaving the market to function on its own. Some patience and lots of market savvy are definite requirements for this plan (but not much money!).
The ECB's balance sheet will expand, at least initially. But it already boasts 1.9 trillion euro in assets, so even if it bought half of all GGBs and Irish Government bonds outstanding at a discount, it would only have to spend some 100 billion euro. With markets being what they are, I doubt it would even have to be that much.

Objections:

It's not ECB's business to bail out nations. Oh really? Is it its business to bail out only financial institutions, then? Let's keep in mind that central banks are, above all else, public institutions working for the benefit of the people. And in such a plan the ECB is not really performing a bailout but a financial intermediation.
ECB may be stuck with too many sovereign bonds for too long. This will happen only if nations themselves don't quickly put their finances in order. Reforms being a necessary condition for participation in the solution, this should not be a serious problem. Once primary budgets are balanced and markets work smoothly, ECB will be able to sell the bonds - perhaps even at a profit.

One final point from the market-participants' point of view: CDSs are wasting assets, i.e. if a credit event doesn't happen within the period specified in the contract (typically 5 years) holders will lose their entire investment. By today's prices of Greek sovereign CDSs, that's $5,000,000 (five annual $1 million payments), paid for covering $10 million face amount of bonds. If ECB adopts this plan it is certain that CDS prices will collapse as dealers try to get out of positions as quickly as possible, further normalizing bond markets.

Ireland (Plus Mrs. Merkel)

2010-11-22T01:21:00.006-05:00

Ireland is about to become the second country in the EU to get a bailout (Greece was first). News and analysis on the subject can be found everywhere, so I'll just throw in a few charts.

Until recently Irish public debt was quite low, around 30% of GDP. But when the property and banking bubble burst things changed very fast. Government liabilities exploded from 60 to 140 billion euro in less than three years (see chart below).

Chart: Central Bank of Ireland

Irish Government Liabilities

The main culprit of Ireland's demotion from prince to pauper is its failed banking system. Ireland boasts a GDP per person that is second highest in the EU (in purchasing power parity terms) and yet... why did they go so massively in debt? The private sector is in debt to the tune of some 350 billion euro (~175% of GDP), with home mortgages alone accounting for 110 billion (see table below - click to enlarge).

Chart: Central Bank of Ireland

Home prices are now slumping across Ireland, but as the chart below shows the bubble was a long time forming.

Chart: ESRI

TSB/ESRI House Price Index

So, what happened in Ireland? In a word, hubris. When it entered the European Union in 1973, Ireland was a poor agricultural society - indeed, the poorest country in western Europe. In a determined effort to bootstrap itself, Ireland focused on education and started attracting foreign (mostly American) manufacturers of high tech equipment and services, offering ultra-low corporate tax rates as an inducement. It worked marvelously well, turning the country from pauper to prince.

And it all went to their head in the end, as it always does in the human race. Dublin became a must-got-to place, a sort of Rome-in-the-Guinness-belt. Home prices soared and kept on soaring, despite the fact that incomes could not possibly keep up with spiking prices. Irish home buyers borrowed heavily and in turn their banks borrowed from abroad, particularly from Germany (note the imbalance between debt and domestic deposits in the table above).

It is estimated that German lenders currently hold about 150-180 billion euro worth of Irish liabilities, making the Irish Problem a very serious one indeed for the German financial system. And it serves as a poignant counterpoint for Mrs. Merkel, the German Chancellor who has made so much political hay at home at the expense Greece, even though German banks hold only some 30-40 billion of Greek bonds.

P.S. A final prediction, for what predictions are worth: Europe is going to go the way of the US in bailing out its economy (-ies) and Mrs. Merkel is not going to make it past April 1, 2011 as Germany's Chancellor.

The Tri-Polar Era

2010-11-10T09:34:00.002-05:00

The Bretton Woods agreement of 1944 established the preeminence of the U.S. dollar as the world's sole reserve currency. The six decades that followed were the Unipolar Era for matters monetary, even after Richard Nixon in 1971 unilaterally canceled the dollar's convertibility into gold.

The Maastricht Treaty of 1992 set forth the requirements for the creation of the euro, the European Union's common currency, which started circulating officially in 2002. Thus began the Bipolar Era, a time of increasing concern for the United States since the euro challenged its monetary preeminence and threatened the very foundation of The Dollar Empire.

America's serial troubles with the stock market crash of 2000, the 9/11 terrorist attacks, the Iraq and Afghanistan wars and the housing and debt implosion which started in 2007 and is still ongoing, have only added to the dollar's woes, since Americans have chosen to combat their intractable socio-economic problems with a mere placebo, an anodyne as it were. To wit, the loosest possible monetary policy and increasingly massive quantitative easing, i.e. the printing press.

Naturally the dollar is losing value against the euro, prompting virulent and under-handed attacks against the latter's credibility by American and allied economists, bankers analysts and associated flotsam and jetsam. For example, the hugely disproportionate negative publicity surrounding Greece's public budget deficit - a laughable 0.25% of the EU's combined GDP.

Much more dangerous for American living standards, however, is the loss of the dollar's value against wheat, corn, copper, gold, oil and all other commodities. The CRB index has zoomed back to its all-time highs not because of strong current or incipient demand from industrial users - the global economy being still quite weak - but because the dollar is increasingly viewed with well-founded suspicion (see chart below).

CRB Commodity Price Index

And that's where the third pole comes in: China has become the world's second largest economy, but when it comes to its currency it is still acting like a poor, underdeveloped country. The yuan's hard peg against the dollar is not exactly a sign of national economic confidence, never mind pride. It's like a 6 ft. tall teenager feeling so unsure about riding a bike that he keeps the side-wheels on.

An economy of such magnitude and global importance as China's cannot and should not use another country's currency, as it is effectively doing now through the yuan's peg to the dollar. "It just ain't natural"- and what's more, it's clearly no longer in China's best interest. To use but one adverse example, what are the likely consequences of QE2 on the roaring Chinese property bubble?

It is time for China to completely un-peg its currency from the dollar and allow it to float freely, thus causing the world to enter the Tri-Polar Era. From the perspective of balancing trade and geopolitical power, the existence of three major globally and freely traded currencies is more desirable than only one, and even better than two (the third will act as a buffer).

Furthermore, a tri-polar exchange regime is far superior to antiquated gold benchmark notions currently being thrown about (hopefully containing no serious intent).

Bernake As Greenspan

2010-11-09T04:33:00.001-05:00

What is Mr. Bernanke doing with QE2 (quantitative easing part two)? By his own admission, he is unleashing a flood of money into the system in order to forestall deflation. And how is more (fiat) money going to help the so-called "real economy"? Again by his own admission, by pumping up asset prices (i.e. stocks), creating a wealth effect and thus giving birth to a virtuous cycle of confidence, consumption and investment.

Here's an excerpt from the link above, an op-ed Mr. Bernanke wrote for the Washington Post a few days ago.

"And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion."

That's an astonishing statement of intent, coming as it does from the Federal Reserve, but let's accept it at face value (but, really, could you ever imagine that a head of the nation's central bank would act as a stock jobber for the S&P 500?).

Still, is Mr. Bernanke's asset-bubble strategy any different from what Mr. Greenspan did following the dotcom whump-and-dump of 2000-02? Oh, not really - except that Uncle Alan chose housing and crappy mortgages, while Brother Ben's choices are shares and Treasurys. I guess the former was burned by his correct but ill-timed Irrational Exuberance comment (and in markets timing is, after all, everything), whilst the latter has no such inhibitions. Yet.

What can I say...? Does it matter what you drink, if you end up face down in the gutter in an incoherent alcoholic stupor?

One more time: what we need, and what needs to be seriously targeted by all concerned, is higher earned income (wages and salaries), not more debt-inflated asset prices.

Period.

Common Sense

2010-11-02T04:50:00.001-04:00

For today's elections I have only one thing to say.. OK, two:

Smart people don't cut off their nose to spite their face.
Remember the Alamo (you know... Bush?).

Enjoy the balloting.

P.S. Here are some rather shocking data on wage distribution in the U.S.A. from the Social Security Administration. (Data refer to 2009 during which there were a total of 150 million wage earners.)

The largest group of wage earners - a massive 24 million or 16% of the total - made between 1 red cent and $4,999.99. On average they earned $2,016.
The average wage for everyone was $39,054, but the median was a mere $26,261. Two thirds of all workers made less than $40,000.

Middle class? What middle class? Look at the data...

An Excellent Idea

2010-10-29T07:14:00.000-04:00

According to Bloomberg: "President Barack Obama will make the case that his proposal to let companies take immediate tax deductions for the full cost of new equipment will help the economy grow and create jobs by encouraging about $50 billion in new investments through 2011."

I think that's an excellent idea. It should be expanded and embraced by other countries, as well.

In my opinion, if the developed world (US, Europe and Japan) is to transform its bankrupt consumer spending economic model (which ultimately involved unsustainable borrowing) it must undertake and sustain very large capital investment, preferably in energy and transportation infrastructure. For example, investing in upgraded electricity grids, instead of shopping malls and ski chalets.

By definition, such an economy involves more knowledge, more technology, more highly skilled workers and more value added per hour worked. That's exactly what "developed" is all about - or should be, anyway. And that's exactly what our resource-stretched, environmentally-challenged world needs, right now.

It would also rather quickly reduce pernicious trade imbalances which are spilling over into the foreign exchange battleground (that's code for US-China relations and the yuan peg).

Congress should move immediately.

Making Real Things For Real People (tm)

2010-10-15T06:20:00.007-04:00

Three years into the crisis we can say that the world did not come to an end, the economy did not fly off the cliff and markets are operating in "safe" mode. Not to mention that Wall Street is smugly preparing to pay huge bonuses once again. Credit must go to the Fed and Mr. Bernanke personally for making so much, well, credit available to everyone who asked for it and even to some who didn't.

But is it, in fact, credit that we must give the Fed?

During the past three years the Federal Reserve has assumed a role never envisaged by its founders or anyone who ever worked there - Mr. Greenspan included, I'm sure. Despite his "heli-Ben" moniker, I even doubt if Mr. Bernanke himself ever truly believed that the Fed would have to go as far as it has under his guidance.

Because it's one thing for the Fed to respond to challenging economic conditions by lowering interest rates down to ZIRP. But it's quite another, a quantum leap (of faith?), to become the major shaping force of the economy by inundating it with so much money as to reverse the natural ebb and flow of capitalism, to forestall what Joseph Schumpeter called creative destruction.

They say that the road to hell is paved with good intentions, and I am afraid that we have all of us allowed Mr. Bernanke to lead us a merry journey that may end in a very hot place, indeed. He has good intentions, undoubtedly: to "save us" from a financial meltdown which could have resulted in another Great Depression. He has used monetary policy to an incredible extent, encouraged, it must be admitted, by an executive branch that was so intertwined with Wall Street as to be practically indistinguishable.

So, monetary and fiscal policy both opened up fire on the Great Recession using the only big guns they could bring to bear: money and government borrowing /spending. They fired so many rounds of such heavy gauge that the "enemy" was stunned and is - at the moment - still dizzy from all the noise and smoke.

But the enemy is definitely not dead, because money-for-nothing and government spending are to him as effective as flash-bang grenades. Lots of smoke, lots of noise - but no damage.

Point: The real enemy is widening income inequality. The vast majority of people have seen their real income remain stagnant for 40 years and had to burden themselves with ever-increasing debt to make ends meet.

Massive debt is, therefore, but the proximate cause of the crisis. It's actually a resulting effect of the ultimate cause, which is high income disparity (see chart below).

Chart: FRB Survey of Consumer Finances

Obviously, easier credit (more debt) and government deficit spending (even more debt) do nothing to solve the income inequality problem, which can be summarized thus: lower and middle income people spend a far greater percentage of their income than the rich, who amass wealth instead. Therefore, it is imperative for the former to have growing income to maintain their spending out of earnings and keep the economy healthy.

The obvious solution, most will say, is as as old as Robin Hood: take from the rich and give to the poor. Really? While the egregious favoritism shown to the rich in previous tax laws must definitely be rolled back, taxation alone cannot do the job of repairing decades of yawning income inequalities. Instead, we should pay great attention to the most fundamental economic concept of all: adding value through peoples' work.

What I am trying to say is that real incremental wealth, and the social "fairness" that results from its more equitable distribution, cannot come about from re-distribution, but only from the creation of new useful real assets that generate added value for society at large. For example, an upgraded electric grid that reduces losses and permits two-way power flow; such an "asset" can be put to work immediately and will generate profits (added value) for all, i.e. it's useful to the vast majority of people. Its design, construction and maintenance will create tens, even hundreds of thousands of new, skilled jobs that will command high wages, precisely because of the grid's profitability. That's how income gaps get smaller (think Ford, Model T, etc.).

Contrast this with trading CDS's. While there is a small theoretical benefit to society at large from such an activity (I could argue that it's actually a cost, but that's another discussion), the benefits that accrue are not real but purely actuarial or monetary, i.e. virtual. Furthermore, because of the nature of the financial industry itself, those benefits end up in the hands of a tiny part of the population which is already super-rich.

In conclusion: we have reached, nay surpassed, the limits of monetary and fiscal policy in dealing with this Great Recession. What we urgently need now is -gasp- an Industrial Policy. Yes, that's making real things for real people (tm).

P.S. There is at least one guy who "gets it". Robert Reich was Labor Secretary under Bill Clinton and has just come out with a book about exactly this matter. Aftershock: The Next Economy and America's Future is well written, well argued, brief and to the point. It also includes several workable ideas on how to close the income gap.

The Peoples' Slice Of The Pie

2010-10-10T03:02:00.289-04:00

Economists are forever trying to come up with theories to explain unemployment and wages. It is always a "hot" topic, and the Bureau of Labor Statistics (BLS) monthly release on the employment situation is arguably the one statistic which can - and does - move markets most.

I won't go into the various economic theories on how wages, unemployment and inflation all come together to shape (or "clear"), the labor market. I have a more fundamental question, instead: How important are wages in today's economy, overall? Or, to put it more precisely, how come we have allowed gainful employment and earned income to become so unimportant?

The following chart shows that wages and salaries as a percentage of GDP have been dropping steadily for 40 years, from a high of 54% of GDP in 1970 to a low of 43.5% this year (see chart below). Including other forms of compensation like pension and medical benefits does not alter the picture appreciably: total compensation of employees went from 60% of GDP in 1970 to 54% this year.

Simply put, then, working people are getting a smaller slice of the economic pie.

Yeah, The Pie Is Bigger But Your Slice Is Smaller

This is as major of a transformation of the economy as it gets but it is almost never discussed by academic economists, who are forever trying to figure out how to model unemployment, or interest rates, or whatever econometric datum strikes their fancy. It's like pondering the price of candle oil while Rome burns. And they get Nobels for it, too!

(A small aside about the Nobel Prize for economics: it was not part of Alfred Nobel's will in 1895. It was instituted and funded much later, in 1969, by Sweden's central bank; it is formally known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Considering its provenance in the depths of Money Central, it's highly unlikely that a more "radical" economist is ever going to be awarded one. )

Anyway, who's been eating the Peoples' Slice Of The Pie (TM) then?

Is it proprietors of small businesses or farms? Hardly. Their income as a share of GDP was 8% in 1970 and it's still around 7% today.

For a clue, look at the following chart of net dividends as a percentage of GDP: they have steadily climbed over the years and literally soared after 2003 to nearly triple what they were in the 70's.

If stock ownership was even somewhat evenly distributed amongst Americans I would have no real problem with this picture. But, it isn't - not by miles and miles. The richest 10% families owned in 2007 a mean $700,000 worth of stocks, while the next 15% owned a mere $53,000. The rest, i.e. 75% of the people, owned next to nothing at all (see chart and table below).

Chart: FRB Survey of Consumer Finances, 2007

The United States, indeed the entire West, has in recent times been transformed from a society defined by the constructively paired work-income relationship, to one oriented towards an asset-debt pair. Even worse, most assets are now owned, controlled and exploited by an ever-shrinking minority of super-rich, forcing the vast majority of the people into virtual debt slaves. That's what Virulent Capitalism is all about, in my opinion.

But does anyone really give a hoot? Are important economists really screaming bloody murder? Are politicians really taking notice? The short answer is no.

Notice my main recommendation on the right: Animal Spirits is an excellent book authored by George Akerloff and Robert Shiller, two economists who hardly fit the classical model. For example, they make mincemeat of the deeply-ensconced theory that humans are constantly acting in their so-called "rational" self interest when they make economic decisions. Akerloff ans Shiller are willing - and scientifically able - to tear down the entire foundation upon which classical economics has been resting for centuries.

And yet...

Whilst they correctly identify the causes of the current crisis and properly point accusingly to all the proper directions, what is it that they recommend as a solution? That the Fed should target credit expansion, i.e. make as much credit available to the economy as possible. Not a word about the huge deficit in earned income, not a peep about the enormous asset ownership gap. Instead, more credit, more debt for the masses.

Sorry guys, that's plain insane.

Don't get me wrong. Animal Spirits is an otherwise excellent book, well worth reading for its spirited departure from classical metrics-based economic theory. Buy it, read it, profit from it. But, my point here is that even such forward-thinking economists atavistically fall back to old remedies when faced with financial crises. It's like a modern day doctor correctly diagnosing TB and then prescribing a long stay in a Swiss mountain sanatorium as a cure. Well, good luck with that...

(Maybe it's because Akerloff's wife is none other than Janet Yellen. Yup, maybe he's being very rational, after all. From a personal peace-in-the-family standpoint, of course. Eh...)

P.S. This post was written during the weekend, so I should seriously consider testing myself for ESP because the Nobel committee just announced its choices for the aforementioned Economics prize - and guess what? They gave it to three economists for their work on unemployment, job vacancies and wages. Same old, same old unfortunately.

Where's The Yen Carry Trade Now?

2010-10-05T10:07:00.001-04:00

Three years ago I was shaking my head at the yen carry trade (As The Yen Strengthens). Today's decision by the Bank of Japan to formally ZIRP (Zero Interest Rate Policy) itself into a corner, to - as it hopes - stop the yen from strengthening further, underscores how far the yen carry has unraveled since then.

This so-called "strategy" of borrowing yen at low interest rates to speculate in financial markets all over the world was one of the major generators of hot money and, thus, a big enabler of the bubble finance that ended up as The Crisis.

In August 2007 I estimated the size of yen-carry money at around $1 trillion, based on data from the Bank of International Settlements (BIS). The updated chart below shows what has happened since then - I call it the rise and fall of the yen carry trade and it largely confirms my initial estimate of $1 trillion. Notice how nominal amounts of yen FX swaps and forwards spiked upwards by about $1 trillion at the top of the bubble folly, only to come down by the same amount as soon as the bubble burst.

Data: BIS

I thought the yen carry trade to be so risky as to be downright foolish, at the time. It made no sense to assume very high currency risk (the yen was at multi-year lows) in order to place highly leveraged bets on instruments providing very small spreads over Treasuries and over borrowing costs. One example was buying second-tier European debt (e.g. Greek government bonds) at minuscule spreads of 50 basis points over bunds. What followed is history, and it is still unfolding.

But now is now, and if I was a betting man - which of course I am, being in this business - I would be quite interested in putting on some new yen carry trades at this juncture.

For the record,

JPY borrowing costs: essentially 0% (assuming, of course, that you can borrow at all).
Greek 10-year bond spreads over bunds: 800 bp
USD/JPY: 84

It Can Be Done: Part II

2010-09-30T02:34:00.000-04:00

A few weeks ago I wrote about how fast Portugal developed its renewable energy sources (It Can Be Done, And Quickly) and referenced a NY Times article. Today, another two articles caught my attention.

Canada Produces Strain of Algae for Fuel details how a company set up to produce Omega-3 food supplements in Halifax, Nova Scotia stumbled onto a strain of algae capable of producing up to sixty times more triacylglycerol oil (a biofuel base) than similar micro-organisms.

Ancient Italian Town Has Wind at Its Back goes into how a small mountainous village in the center of Italy installed a few wind turbines and is now a net electricity producer, generating extra income for community purposes.

It is increasingly obvious that green/renewable energy is fast becoming a reality outside the U.S. , which is still stubbornly stuck in an energy Middle Age. It's like Americans refuse to see past their own neck of the woods. They are willfully blinded by the supply of cheap, but vastly inefficient, "timber" from their forest and cannot accept that "trees" are becoming scarcer and dearer in more ways than one.

Let's wake up and look things squarely in the eye: the only way to promote fast development of renewable energy is to make it economically attractive via direct positive and negative incentives (guaranteed prices and taxation). Everything else is wishful thinking and hot political air.

The second article says it well:

At the same time, the costs of renewable energy have been falling rapidly. And as in much of Europe, the lure of alternative power here was sweetened by feed-in tariffs — government guarantees to buy renewable electricity at an attractive set price from any company, city or household that produces it.

In the United States, where electricity is cheap and government policy has favored setting minimum standards for the percentage of energy produced from renewable sources rather than direct economic incentives like Europe’s feed-in tariffs, stimulating alternative energy has been only mildly successful. But in countries where energy from fossil fuels is naturally expensive — or rendered so because of a carbon tax — and there is money to be made, renewable energy quickly starts to flow, even in unlikely places like Tocco.

Many will say that such policies and direct government interventions are not the way America does things, or that it makes no sense to raise energy prices and taxes during a crisis. I strongly disagree. We urgently need to look at alternative energy as a driver of growth, instead of as a drag. As the world's biggest consumer of energy (see chart below), the United States can and should revamp its energy regime.

Data: EIA

The sheer size of American energy consumption means that changing the outmoded energy infrastructure will take a long time to accomplish; but that's is a good thing, it's a way to create millions of new jobs, technical know-how and investment spending, i.e. activity that will sustain the real economy for decades.

Notice how the renewable energy articles are ratcheting up to much bigger economies. It is perhaps easy to dismiss developments in tiny Portugal (#37 by GDP) or Denmark (#31). But Italy (#7) and Canada (#10) are the real deal, ladies and gentlemen. If we continue to ignore such news, preferring instead to keep our heads in the sand, we will end up in the "Empires For Recycling" bin of history.

Just ask the Athenians. Or the Romans. Or the Brits.

The (Unholy) Trinity Of Money: Holy Smoke!

2010-09-28T02:33:00.001-04:00

Money as religion? Well, of course, since modern money is all about faith (lat. credo > credit) imposed by fiat (therefore, fiat currency). Therefore, it strikes me as very funny that money exists in three concurrent states, just as Christianity has its own holy trinity to make up one god. (If you are more scientifically oriented you may also draw a parallel with the triple point of water.)

Let's see:

Money is a medium of exchange for goods and services. This function of money is the oldest and most important in our daily lives, at least for the vast majority of us (see further below why it's not so for everyone). Money-as-go-between goes back thousands of years to Mesopotamia and is at least as major a human invention as the written word and the wheel. It greatly facilitates the smooth functioning of the barter part of every economy, allowing for the formation of cohesive societies. It really does not matter what "money" is, as long as everyone agrees to a common convention and it has an element of scarcity. Cowrie shells, salt, stone tablets, precious metals.. all can and have been used as money in the past. This is the state of money that everyone understands, even a six-year old. Let's call this the Father State.

Money is a storehouse of value. This state came relatively quickly after money became widely accepted and circulated. The Athenian silver owl was probably the world's first global reserve currency, right around the fifth century BC. In this state, people accumulated money instead of valuable resources such as food, fuel, livestock or land. They did so because money was easier to store (e.g. in a small strongbox instead of earthen jars full of wheat) and - very crucially - because they believed they could readily exchange it for valuable goods and services with minimal, if any, loss. In simple terms, a silver coin minted by Athens was assumed and expected to always be exchangeable for a given quantity of wheat or timber, all other things equal. This is when the concepts of inflation, seigniorage and debasement came into play, followed by monetary imperialism in the heyday of the Roman Empire. Most people are familiar with this state of money, too, because they are still mentally stuck with popular images of vaults full of gold backing our money (it's not true). Let's call this the Son State.

Money is an asset. An asset is something that produces regular, periodic returns: a piece of land tilled or grazed by animals, a herd of domesticated animals, equity in an operating business that produces valuable goods and services, etc. However, the concept of money itself as asset (i.e. debt which produces interest), was not widely accepted until quite recently. In fact, the world's two major religions, Christianity and Islam, considered lending of money at interest a major sin (Islam still does, even if only in theory). This is money's most pernicious and least understood state, completely ignored by the vast majority of people. Therefore, let's call this the Holy Smoke! State. (Aptly enough, water also has a vaporous state.)

I obviously don't have a problem with money's Father and Son states, but Holy Smoke! gives me the willies. How could money possibly be an asset, for example a bond?

Consider: a government issues an interest-bearing bond denominated in fiat money. Ignore the principal for a minute, let's just assume it keeps getting rolled over at maturity. But what about the regular, periodic interest that asset-holders demand? Where is that going to come from, huh?

We have become so accustomed to such illogical nonsense for so long that we have come to think of money-as-asset as common sense, day-to-day reality. But if we stop and really think things through we come to the inescapable conclusion that we are dealing with smoke and mirrors. Holy Smoke! by golly!

I previously said there are people - a class of people, really - for whom money as a medium of exchange is not very important. What I meant is that there is a small minority of wealthy rentiers of Holy Smoke! for whom the other two "states" of money are almost entirely insignificant. Another way of saying it comes from Wall Street's past: Gentlemen prefer bonds.

As things have developed lately it is this small minority that is calling the shots for everyone else, i.e. the finance tail is wagging the entire economic dog, now more than ever before. The borrow-consume-grow economic model that was espoused - and is still espoused in the guise of government "bailouts" - led to such an explosion of debt world-wide that Holy Smoke! is now the only form of money that really matters, the state that calls the shots, if you want.

This is completely unprecedented in economic/monetary history. It is even entirely wrong to compare today with the Great Depression and to attempt to draw parallels, examples, lessons or possible solutions from it. This is a new reality, so new as to have become invisible to politicians and economists who operate under the principle that if you can't "see" it, it doesn't exist. (To be fair, that's how most of us operate day-to-day, anyway.)

And here we are today, just like the Easter Islanders refusing to accept that building ever more stone edifices to our own Holy Smoke! deity does not constitute a real solution.

Moai In Easter Island

Default Is Class Warfare

2010-09-26T01:57:00.001-04:00

Many people believe that debt is more-or-less equally distributed across all social classes and therefore cancels out amongst them. The example that is frequently, if totally erroneously, used is that Joe Janitor borrows money from Pete Policeman who has deposited his savings at a bank. Unfortunately, this type of financial reality only exists in the movies - for example in "It's A Wonderful Life" with its Bailey Building and Loan Association. In the film bankers are the good guys who try to create social justice and equality by lending to one and all, while an evil slumlord is trying to bring them down.

However, "real" financial reality is much closer to a much older work of fiction: Dickens' "A Christmas Carol" and the chasm separating Ebenezer Scrooge from Bob Cratchit. That is to say, a small percentage of people (the "monied" class) hold as assets the debts of everyone else.

With this is mind, I maintain that the assumption, service and ultimate default of debt is best analyzed and understood not in terms of straight economics but as aspects of political and social science, at least where household and public debt is concerned (public debt being another form of personal debt, since it is assumed in the name of the people). Straight economics - if there ever was such a thing - is completely inadequate to help us understand the dynamics involved, particularly when debt exceeds a certain percentage of income and becomes onerous.

Most every politician and economist will forcefully say the same thing: default is equivalent to disaster. Really? Why?

If the "bottom" 90% of the people owe their debts to the "top" 10% and can no longer generate enough earned income to service them and maintain a decent lifestyle, isn't default a great benefit to them? Doesn't the destruction of debt - if properly handled, mind you - create social and economic justice for the vast majority of the people? Or should the 90% keep slicing off pounds of flesh?

Yes, default means that the top 10% will suffer a radical diminution to their accustomed living standards, but is this so bad? To paraphrase: "Where Are The Peoples' Yachts?"

So far in this crisis we have fought fire with more fire as our collective governments have forced the people to assume even more debt, purportedly to "salvage" the likes of AIG and Greece. But it isn't them who are being "saved", of course, but their creditors. How fair is that?

One of these days "the people" will wake up and realize that properly managed debt default is far and away to their advantage but I am not holding my breath. Social-political leaders and their media mouthpieces are default atavists - or, more precisely, are paid to be.

I'm Back. It's Nice To Be Missed

2010-09-14T07:11:00.001-04:00

It's always a great compliment to be missed (and not misplaced).

My absence was caused by a combination of vacation (yes, Debra, it involved the love of my life, long walks along isolated sandy beaches, attempts at poetic expression and even a lovers' tiff or two), moving houses and a change of schools for the kids. Now, that's what you call a killer combo - for blogs, anyway.

Rorvig

I managed to get my Internet service up and running again last night, so here I am - if more than a bit behind on global economic goings-on. Though I will catch up in the next couple of days, it's comforting to know that the world does not float on a bed of hot air emanating from yours truly.

Till later...

It Can Be Done, And Quickly

2010-08-10T01:46:00.004-04:00

As this article from the NY Times about Portugal makes very clear, transition to a renewable energy regime can be accomplished, and very quickly at that.

"Today, Lisbon’s trendy bars, Porto’s factories and the Algarve’s glamorous resorts are powered substantially by clean energy. Nearly 45 percent of the electricity in Portugal’s grid will come from renewable sources this year, up from 17 percent just five years ago."

Apparently, they have hit all the right buttons: grid modernization, emphasis on wind and hydro, two-way power flow to and from customers who have rooftop solar panels.

Yes, all it really takes is political will. The rest is just money (and we know what that is really worth..).

By contrast, the real costs of relying on fossil fuels are:

Massive geopolitical risk, which translates into the cost of maintaining an enormous "defense" establishment and occasionally fighting energy wars, as we are doing right now.
Environmental degradation and climate change.
Losing our technological edge as other countries and entire continents (e.g. Europe) move towards more sophisticated energy regimes. For example, the Portuguese electricity company EDP already owns wind farms in Iowa and sells electricity to the Tennessee Valley Authority. Instead of moving ahead, the U.S. is dumbing-down.

In the 1950's and '60s rich American tourists visited remote villages in poverty-stricken Spain and Portugal, frequently snapping pictures of themselves riding donkeys and mules. The poor locals were befuddled, since they would gladly have exchanged their picturesque animals for a tractor or - gasp - an automobile, if they could afford it.

I fear that in 2050 rich Spaniards will be visiting West Virginia or Utah to pixelize themselves driving ancient gasoline pickup trucks, which the locals would gladly exchange for a 300-mile range electric model, if they could afford it.

Global Warming? Nyet, Nyet..

2010-08-07T00:40:00.001-04:00

No, there's no fossil-fuel induced global warning. Absolutely not. The 100 degree Fahrenheit (38 Celsius) temperatures in Moscow (25 F higher than normal, hottest since record-keeping began 130 years ago) is a direct consequence of sunspots, the tilting of the Earth's axis, too much vodka on the air and cow farting.

Well, OK.. there is some fire where the smoke is coming from and it is making life difficult for Muscovites.

Photo: The NY Times

The Kremlin Shrouded In Smoke

The record heat and drought are threatening Russia's wheat production, prompting the government to suspend all wheat exports for a short period of time and setting off gyrations in futures markets.

But, hey, Muscovites should enjoy the haze since it protects them from sunburn; as for the rest of us, we can all eat cake.

The Real Cost Of Oil

2010-08-03T23:52:00.000-04:00

It is estimated that a total of 5 million barrels of crude oil have leaked from BP's Deepwater Horizon site, making it the worst oil spill in history. And as of last night, the company's market capitalization was down a total of $62.5 billion when compared to before the disaster. The loss was even bigger before the rebound, at $106 billion, see chart below.

Price of BP Shares

So what's the cost of a barrel of oil? For BP, it's definitely a case of crying over spilled crude: doing the division it comes to $12,500 per barrel - and it was even more before the bounce, at $21,250/bbl.

If we go a bit further and amortize the loss over BP's entire crude oil plus equivalents production for a whole year, it comes to $43/bbl. And if we go all the way and amortize the market cap loss over their entire proven reserves, it comes to $3.40/bbl. (Data from BP's 2009 Annual Report.)

Choose the number that best reflects "reality" in your view - it's only money, after all. However, it does put a number on one of those "external" costs for oil.

Now... what's the cost for the Iraq and Afghanistan wars?... hmmm.

Goodbye To All That

2010-07-26T02:40:00.003-04:00

The United States Senate just failed to pass climate-change legislation. Thus, unless our "leaders" perform an immediate about-face, the oil and coal interests can sleep soundly at night - as long as they keep their air-conditioners blasting away at full power, of course.

Here are two links from people who are much better at venting frustration than I am:

"Who Cooked The Planet?" by Paul Krugman.
"We're Gonna Be Sorry" by Thomas Friedman.

All I have to say is that the downfall of empires is obvious not only to historians armed with hindsight, but also to contemporaries possessing a minimum of common sense. (I bet there was not a single Roman above plebeian level who would deny that Caligula or Nero were horrible choices.)

And thus, today's title: Goodbye To All That was Robert Graves' first novel - the same author who went on to write I Claudius and Claudius The God.

So, dear Senators (what a coincidence that you ladies and gentlemen have the same title as those Roman fools) you just made it a lot easier for the US to go off the cliff. How do you feel, strapped on to your senatorial chariot (or is it a tricycle?).

Two Simple Rules For A Quantum Reserve Currency

2010-07-11T03:03:00.001-04:00

Vacation Notice: Beach time for the next couple of weeks.
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Do you know how Athens got to be a major "global" power during its Golden Age of Pericles? (Actually, it hardly qualifies as an "Age" since it only lasted roughly from 450 to 430 BC, a reminder of the ephemeral nature of power.)

Was it the rise of democracy, their large and powerful navy, repeated victories against the Persian Empire, civic pride in their cultural excellence, the creation of colonies and trade all over the Mediterranean and Black Seas... ? Or, was it that they simply discovered lots of silver right next door to the city of Athens in 483 BC?

The Laurium silver mines were the property of the Athenian state and were worked exclusively by slaves. The precious metal was minted into coins which were widely circulated and used in trade all over the world. More than a mere medium of exchange, the Athenian Owl became history's first global reserve currency.

Yes, we can thank (or curse) the Greeks for that, too.

Athenian Silver Owl, 5th Century BC

I'm not sure if the Athenians were then first to debase their currency as well, but by Roman and Byzantine times debasement was a common way to deal with economic problems and to cover state revenue shortfalls through increased seingiorage. Of course, this created even bigger problems, since currency debasement was (and still is) the surest and quickest way to impoverish the population through the decline of their purchasing power.

However, one advantage of specie money (precious metal coins) was that, unlike today's fiat currency, its elevation to reserve status did not require an a priori religious belief in its soundness (see picture below).

Guess Why The Lord's Name Is Invoked Here?

Another, was that its debasement was immediately apparent to everyone. For example, when the Roman denarius got smaller and/or lighter in silver content even the lowest plebeian knew he was getting screwed - and who was to be blamed, for that matter, since his face was on the coin itself (*). That's pretty democratic, in a practical, let's-grumble-on-the-way-to-the-forum fashion.

By contrast, today's currency debasement occurs through a mechanism entirely obscure to the vast majority of people, whose nebulous understanding of monetary matters still involves cinematic images of gold ingots kept in underground vaults. This wasn't true even in Goldfinger's time, never mind today.

Anyhow, it's been a long time since precious metal coins were used in everyday transactions, and it's even been one hundred years since the gold standard started unraveling.

What replaced it was paper and then electronic fiat money; today we even have "shadow" money, a creation of the shadow banking system. Fiat money was a concept as modern as quantum physics; interestingly, both appeared around the same time, in the first part of the 20th century. Modern money shares a common foundation with quantum physics because, just like quantum states, our money leads an indeterminate probabilistic existence until we interact with it, i.e. until we try to use it for a concrete purpose.

For example, what is the "value" of a dollar? We measure it by comparison to a "known" quantity, like a bar of chocolate. Today, a dollar may buy one bar but tomorrow it may be worth only nine-tenths, or eleven-tenths. The astonishing conclusions from Schrodinger's cat point to more directions than the probabilistic nature of photons only.

Alright, now for those "simple" rules for a global reserve currency.

First, we must keep in mind that our money is, in fact, a quantum currency, i.e. its value is not fixed but relative, highly dependent on what people think it is worth. In quantum physics the equivalent - and much more general - principle is that reality is created through our observation and is therefore not independent of us.

However, people also want their money to be "stable", just like they prefer to perceive reality in terms of comfortably deterministic Newtonian physics, not as probability wave functions or multiverses. Squaring the two is not an easy task, very likely because as humans we have not yet evolved far enough to routinely function in a quantum existence.

We conclude, therefore, that a global reserve fiat currency must continuously and dynamically balance between its inherent quantum uncertainty and the human desire for determinism. To occupy, if you like, the space between quantum and Newtonian monetary mechanics.

Therefore, these are the two rules for today's reserve currencies:

First Rule: Information is key.

The only way to reduce uncertainty is to possess as much clear and unambiguous information as possible. That won't make a quantum currency behave 100% deterministically (that's impossible), but it will reduce risk.

For example, if the Fed is vague about what it is doing to its balance sheet, dollar investors will calculate a higher probability of debasement. Likewise, when the government drops regulation of important financial markets, or allows them to grow unchecked over the counter, or when finance becomes dominated by a few large, secretive players.

Alan Greenspan as Fed Chairman subscribed to the exact opposite idea as he befuddled everyone with his tortured syntax, i.e. he essentially maintained that what you don't know can't hurt you. His cavalier attitude towards the public's ability to understand monetary matters (a gross misreading of Ayn Rand) must share the blame for the creation of the Debt Bubble. By contrast, the ECB at least tries to be more open about its operations.

Second Rule: Adopt A Modern Yardstick

Since the only way to define a currency's value (i.e. to provide more information about it) is by comparison to a known quantity, we urgently need to adopt a "yardstick". In the past we used the gold standard, but for many reasons this is no longer a useful benchmark. I propose that today's money supply growth be fixed relative to the rate of growth of renewable energy, thus killing two birds with one stone: money will have a known, useful benchmark and the economy will be forced to function in ways that will quickly address resource and environmental concerns.

You can read more about it in an older post: The Greenback - Toward A New Monetary Policy.

Does the dollar, today's global reserve currency, follow these two simple rules? Sadly, it does not.

________________________________________________________________

(*) In contrast to decrepit Roman emperors, today's fiat money issuers are a lot wiser about who is depicted on their money. They prefer such anodynes as long-dead presidents or, even more neutrally, doors and bridges in the case of the euro.

Money, Money, Money

2010-07-03T12:17:00.000-04:00

Money makes the world go round, so here's a simple question: how much of it is there, at least how many U.S. dollars? Here are some charts.

First, M1 money stock (for detailed definitions see the bottom of today's post).

Charts: St. Louis Fed

M1 Money Stock

A closer inspection shows that M1 shot up 20% in just twelve months during 2008-09 (see chart below).

M1 Money Stock (detail)

MZM is short for money, zero maturity and is a better representation of institutional money, i.e. the money that sloshes around investment banks, hedge funds, etc. It, too, jumped 20% in the same period.

Money Zero Maturity

Since 1980 total debt outstanding, arguably the broadest possible definition of money, has kept pace with MZM. In the last 30 years total debt rose from $5 trillion to a little over $50 trillion, and MZM went from $1 trillion to a touch under $10 trillion. In other words, both increased tenfold (see chart below).

Data: FRB

Total Debt Outstanding (USA)

Looking at debt in greater detail shows an interesting departure from this correlation during the 12 months of mid-2008 to mid-2009. Total debt rose slightly less than 4% (see chart below, red rectangle).

Total Debt Outstanding (detail)

How is this possible? It's a direct consequence of the massive intervention by the Federal Reserve: it took problem loans and structured bonds onto its own balance sheet, removing them from the likes of Lehman, AIG, Bear Stearns. In exchange, the central bank essentially "printed" money, i.e. obligations of the US federal government. Many of those bonds have since proved to be worth a lot less than the money printed in exchange, and many of them are entirely worthless.

The increase in MZM in 2008-09 was $1.5 trillion, the same as total debt. Net-net, therefore, zero. Obviously, no 10X multiplier effect came into play here, since the Fed's money went to replace debt gone bad and not as high-powered money to make fresh bank loans.

And what about out and out deflation on a grand, monetary scale?

Well, it obviously hasn't happened yet since total debt has not come down appreciably. And such deflation won't happen for as long as people still trust that the "money" going around still acts as a safe storehouse of value. In other words, for as long as people are still willing to believe that its issuer won't go belly up, too (Uncle Sam in this case).

But as the travails of Greece (and Spain, Ireland, Iceland, etc) show us, such trust can be a tricky thing, indeed. No wonder the Chinese are stockpiling base materials as fast as they can, paying for them with their piles of dollars.

Definitions from the St. Louis Fed.

M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts. Seasonally adjusted M1 is calculated by summing currency, traveler's checks, demand deposits, and OCDs, each seasonally adjusted separately.
M2 includes a broader set of financial assets held principally by households. M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs).
MZM is M2 less small-denomination time deposits plus institutional money funds.

Monster Index

2010-07-02T06:20:00.000-04:00

Right before the BLS employment data, a chart of the Monster Employment Index. (*)

Monster Employment Index

The index is now back to 141, where it last was almost two years ago (November 2008 = 143). The year-on-year comparisons are quite strong (+21%) but the absolute level of job demand remains quite weak versus the all time high readings reached in 2007. Still, it is a sign that the private-sector labor market has stopped deteriorating and is showing tentative signs of demand.

Note that this index is not seasonally adjusted.

(*) "A broad and comprehensive monthly analysis of U.S. online job demand conducted by Monster Worldwide, Inc. Based on a real-time review of employer job opportunities culled from a large, representative selection of corporate career sites and job boards, including Monster, the Monster Employment Index presents a snapshot of employer online recruitment activity nationwide."

Fractal Finance, Part II

2010-06-28T02:43:00.001-04:00

In Fractal Finance, Part I we saw that fractals can be useful in describing complex, seemingly chaotic patterns in nature. We also saw how Wall Street took advantage of the same advances in information technology that made the study of fractals possible starting in the 1980s, to come up with computer-driven black-box trading schemes. For example, index arbitrage strategies were widely blamed for the Black Monday crash of October 1987.

Wall Street is always on the look-out for new "angles", opportunities to better skin a cat in a place already full of very sharp razors. The sheer quantity of money moving around attracts very bright individuals, at least the variety who get high on making as much money as possible with the seat of their pants and the money of others. Wall Street is also home to some of the hugest and most ruthless egos to be found anywhere, resulting in a kind of kindergarten for genius gunslingers, but that's material for a subsequent post.

Unlike what most people may think, professional traders don't usually make huge "straight" up-and-down bets; there's simply too much risk involved. They leave this type of activity to end-user speculators and investors (e.g. hedge or pension funds), and mostly involve themselves in market-making and arbitrage.

Market-making is the workaday, mundane function of providing secondary market liquidity in return for a thin "spread" profit between bid and offer prices. This is the foundation upon which rests most trading revenue and is the training ground for all junior traders.

The real action, however, where whiz-kids can and do make a difference playing with the firm's own money, is in arbitrage and arbitrage-related activities, where profit margins are modest but risk is usually well-defined, small and manageable. The trick there is to identify new "angles" and take advantage of them early on, when profit margins are still fat, i.e. before other players get a whiff of the action and pile in too.

(If you are not familiar with arbitrage and risk, Richard Bookstaber's A Demon of Our Own Design is an excellent and enjoyable book, written by a true insider. Also, see the personal note at the end of this post.)

The basic principle of arbitrage is simple: if A=B and B=C, then by definition A=C. Financial arbitrage is, of course, more complicated than simple math since it involves a variety of different risks, ranging from simple execution risk (the ability to complete a trade as planned), all the way to counterparty risk (an entity on the other side of the trade fails).

The basic elements common to all arbitrage operations are:

The amounts of money involved are very large. Since profit margins are small a lot of capital must be applied in order to make a decent return, in dollar terms.
Trading is very active. Again, because of such small margins, which can appear and disappear within minutes, if not seconds, traders have to pounce on them fast and often.
Heavy leverage is always used to boost returns. Twenty-to-one is considered conservative, fifty-to-one is standard and 200-to-one is not unheard. (Or was, we now live in the Age of De-leverage).

And where do fractals fit in? Where is self-similarity in markets?

One does not need to study price charts in major, liquid markets for long to realize that they look very similar in all time frames. Do this: take the daily chart of any reasonably active stock or commodity and start narrowing the time frame, i.e. reduce the time unit to hourly, 30-minute intervals, 10-minutes and so on. You will see that fluctuation patterns are, more or less, similar. Now, expand the time frame by looking at weekly, monthly, etc. charts. Again, similar patterns.

S&P 500 - One Day Chart (Friday, June 26 2010)

S&P 500 - One Year Chart

The study of patterns is not new in markets, of course. It has been going on for ages as technical analysis, wave theory, Fibonacci trading, etc. What is new, however, is the massive size of computing, communications and network capacity now being applied to markets, causing trading to become unrecognizable when compared to even ten years ago. It is estimated that an astonishing 70% of all volume in U.S. stockmarkets is now driven by so-called "high frequency" trading, where buy and sell orders are generated by algorithms residing in black-box computers, taking advantage of arbitrage opportunities between the prices of shares, indexes, trackers, futures and other derivative instruments.

In Part III I shall present my conviction that such developments are detrimental to the overall health of financial markets and, indeed, the entire real economy.

________________________________________________________

I first heard of the words arbitrage and arbitrageur in 1981 during the Mobil - Marathon - U.S. Steel takeover battle. At the time, I was in grad school getting my Master's degree in ChE - and mentally a million miles from Wall Street though a stone's throw away.

I was introduced to David P., a major-league arbitrageur at the time, who tried to explain what he did. I found it all extremely boring in those, my early Joe Engineer days: oil prices were setting new records and Wall Street was flat on its back. It wasn't until several years later that I realized who David really was. Or, for that matter, who one Carl Icahn was, whom I had met at one of David's parties and, having never heard of him until then, cheekily asked: "And what do you do for a living?" I still blush at my ignorance.

China Revalues Yuan: It Takes Two To Tango

2010-06-21T13:22:00.002-04:00

Fractal Finance, Part II will follow on the next post. I believe China's decision to revalue the yuan merits a post first.

______________________

Following months of wrangling with the United States, during which unsubtle threats of trade war were hurled hither and yon, China finally announced yesterday that the yuan's peg to the dollar will be allowed more flexibility. The currency "jumped" 0.2% higher versus the dollar. If this revaluation seems unimpressive given the intensity and importance of the matter, that's because it is unimpressive. But, China does things its own way, particularly during its current transition from a command economy to free-market capitalism. Old habits die hard, absolute power corrupts absolutely, you can't teach an old dog... you get the point.

But the yuan's revaluation is not exactly my subject today. Instead, I want to focus on something Hank Paulson said back in his final days as Treasury Secretary: The world, he said, was suffering from a "savings glut" - and pointed at China and the oil producers.

Now, back then I thought his comment was disingenuous, if not downright asinine. After all, I clearly saw the problem as a sea of bad debt and the popping of the easy credit bubble. But, as if often the case, it takes two to tango and, in fact, some concepts can only be defined in relation to their matched opposites. Good requires evil, light makes sense only because of darkness, ying needs yang.

Likewise, for every incremental unit of savings to exist we must, by definition, create an incremental unit of debt. Interestingly, however, debt can be, and mostly is, today created out of thin air, a situation otherwise known in theology, cosmology and other such -ologies as creatio ex nihilo. Furthermore, unlike other matched pairs, the creation of fiat currency debt-savings is strictly unidirectional, i.e. it is the willingness (or necessity) to assume debt that creates savings and never the other way around. I can walk into a bank and apply for a $1 million mortgage, thus putting into motion a process that may ultimately result in, say, the holding of a CMO by a bank in China, i.e. a piece of the "savings glut".

But I can't do the opposite: I can't stroll into a bank and ask it to generate $1 million in savings for me. That's the crucial - if obvious - difference within the duality of money as debt and debt as money. In other words, sure it takes two to tango - but there is only one leading partner on the dance floor: the borrower.

Stop right there, you cry. Didn't all parties on the other side of the credit bubble, the mortgage and leveraged loan originators, the brokers, packagers, servicers, rating firms, the investment banks.. the whole nearly-criminal gang - didn't they salivate and cry out for ever more "product" to chop and shop around as CMOs, CLOs, CDOs? What do you make of that?

Well, I say that if people had decent incomes from decent jobs and could thus afford to live a middle-class lifestyle and save a bit on the side, as they did up to the mid-70s, well then they wouldn't need to borrow to cover the most basic necessities of life. Like a home, an education and medical care. Who ever imagined it was normal to go into hock for years on end just to pay for a college education, for heaven's sake?

So, to go back to Hank Paulson. Indeed, he spoke truthfully - from an accountant's point of view. But oh, what a tangled web of (half)truths we weave, when we set out to deceive.. It's not like a billion Chinese came begging to America to create a trillion dollars' worth of a "savings glut" for them now, is it?

And how about China? What is it doing with all that debt-uous "money" it has piled up over the years? It is in a lather trying to convert it as fast as possible into "hard" assets, like oil and iron ore deposits, ports, etc. That's a game of "hot potato" on a grand scale or, quite literally, "pass the buck".

Maybe now we better understand why there was such an absolute need for the dollar to go up against the euro, the only serious adversary for global reserve currency status, eh? Particularly since the US is creating another trillion-plus dollars in fresh "savings" this year...

Fractal Finance, Part I

2010-06-17T00:05:00.005-04:00

Dedicated to the memory of Dr. Thai McGreivy

_____________________________

Fractals are everywhere in nature: a bush by the side of the road, the pattern of electrical discharge in lightning, a piece of broccoli, the shell of a nautilus, frost crystals.. In short, the apparent complexity of natural shapes can frequently and elegantly be described by simple mathematical iterative functions. For example, the Mandelbrot set is generated by the iteration of the complex polynomial z_n+1 = z_n² + c. Its plot on the complex plane leads to shapes of breath-taking beauty.

Fractals exhibit self-sameness, i.e. no matter how small or large the "piece" that one observes it always looks the same - or very similar - to the whole. For example, a florette of broccoli is essentially a smaller-scale replica of the entire head. This is very obvious in a particular variety of broccoli, pictured below.

Romanesco Broccoli

The study of iterative and recursive mathematics goes back centuries. But widespread study of fractals really took off when personal computers made massive iterative computation and plotting available to everyone. For example, you too can download your very own fractal software here (chaospro).

My first exposure to fractals (though I didn't know them by that name back then) came in graduate engineering school, when a professor started talking about chaos functions and how they could possibly be used to model and ultimately predict share prices. I didn't pay attention; the world was in the the final stages of the oil crisis (Iran hostage era), oil prices were zooming and I was a committed Joe Engineer who cared much more about modeling weight-distribution equations for the products of synthetic fuel reactions.

Oh yes, we engineers would have saved the world, don't ya know, and salvation didn't involve stocks, bonds or mutual funds. Financial markets were moribund, anyway.

Of course, the bull started its historic run right then, in August 1982, with impeccably contrarian timing. They say "no one rings a bell at the beginning and the end of bull markets", but that's wrong. Look at the chart below: markets do ring bells, but most people are too busy listening to the ambient noise, instead.

August 1982: The Bell Tolls For S&P 500

It was around the same time that IBM came out with the PC and Benoit Mandelbrot's work was first noticed by the financial community (he worked at IBM for 32 years starting in 1958). It was the era of the random walk hypothesis and his fractal formulas were a slap on the face of mathematical economists (not that many took notice). He claimed that markets weren't random but fractal, i.e. exhibited a complex behavior that could be broken into smaller and smaller self-same bits. The idea was that price fluctuations could be described by fractal functions, i.e. they were not random and were, thus, predictable - maybe. He eventually wrote a book on the subject, The (Mis)behavior of Markets

To the army of academic economists who had religiously staked entire careers (and Nobel prizes) around the exact opposite notion this was heresy on a grand scale. The application of fractals to finance looked suspiciously like the hocus pocus of financial astrology, a kind of mathematical alchemy that sought to transmute simple formulas into traders' gold.

On Wall Street itself, marketing and trading departments didn't pay much attention, since they were busy selling "scientific" portfolio management based on the academics' random walk theories. Their apple cart was hitched to a different, and differently profitable, horse and they saw no need to upset it.

Furthermore, most financial firms did not yet possess the massive computing capacity necessary for fractal calculations. They were still in the initial stages of stitching together communications and data networks for their day-to-day operations and didn't have the time or resources for fractal mumbo-jumbo. The age of information had dawned, but it was still early days.

But, things change. By the late 1980's computers were increasingly used for crude black-box trading (crude by comparison to current practice). It involved mostly arbitrage between share prices, index futures and options and it is considered the culprit of the October 1987 meltdown. The market was horribly overextended and due for a correction, anyway, but the speed and depth of the plunge took everyone by surprise, myself included.

Left unattended, computer programs kept issuing sell orders for baskets of shares to "profit" from price discrepancies with index futures. Algorithms saw shares as mere numbers, mathematical data points with no physical correlation to a company's products, plant and equipment, technological know-how, profits, jobs or any other fundamentals. That's what you get when you mix simple math with the base emotions of fear and greed - and by the time human beings came to their senses the Dow was down 22% in a single day, now dubbed Black Monday.

The Market Burps on Black Monday, October 1987

In Part II, coming shortly, I shall examine what happened next and how we are now in the completely uncharted seas of Fractal Finance with robotic, high speed trading.

Je T'Aime Moi Non Plus

2010-06-15T02:41:00.004-04:00

Remember how just a few weeks ago Frau Merkel and Monsieur Sarkozy locked horns about bailing out Greece and potentially just about everyone else? (I wonder, who will eventually bail out the bailiffs?) . Well... the pair have now decided to put on a brave show of kiss, kiss, no tell - for the good of their Union, you understand.

Photo: WSJ

To symbolize their re-found and re-energized affection for each other, the pair have also chosen a song, once very popular during their more.. how shall we put it... salubrious days.

Take it away, maestro...

From Wikipedia:

Je t'aime moi non plus.. "was originally written for and recorded in 1968 with Gainsbourg's then girlfriend, Brigitte Bardot. However, Bardot pleaded with Gainsbourg not to release their recording of the song: she was married at the time, to German businessman Gunter Sachs. Gainsbourg complied. Later that year, Gainsbourg met, and fell in love with, English actress Jane Birkin, on the set of their film Slogan. "Je t'aime... moi non plus" was re-recorded with Birkin replacing Bardot, and was released early in 1969".

P.S. For franco-challenged readers, Je t'aime moi non plus translates to I love you ..me neither. Wink, wink, nudge, nudge, say no more?

Hell Goes Soft (er)

2010-06-14T03:22:00.004-04:00

A note on the new look of Sudden Debt.

Tiffany blue, baby blue.. call it whatever, the new design and colour palette of Sudden Debt is undoubtedly much "softer" than the previous harsh red and black, deliberately chosen over four years ago as a warning to the looming dangers of the credit bubble. The blog not only sounded but even looked accusatory, as if Sudden Debt was the Spanish Inquisition and yours truly the Torquemada of Debt, committing heretical lenders and borrowers to burn in, well, Hell.

Since then the credit bubble has burst spectacularly and today there is not a soul on this planet who has not heard of sub-prime lending, credit derivatives, sovereign default probabilities, etc. In other words, Sudden Debt has accomplished the mission of warning about, chronicling and lambasting the Permagrowth culture that was founded on ever-expanding credit and inflating asset prices. To continue doing so would be akin to beating a dead horse, a function entirely foreign to my outlook and interests in life.

So, where do we go from here? For one, I believe it is imperative to now make fun of High Finance instead of continuing to accuse it of malfeasance. The reason is as simple as Charlie Chaplin's The Great Dictator. Ridicule is an extremely potent weapon, when used judiciously.

To this end, here are a couple of classic clips from my favourite Brit comedy show, Monty Python's Flying Circus. Watch both, they are quite short.

The Spanish Inquisition, Part One

The Spanish Inquisition, Part Two

They no longer make stuff like this, unfortunately. Today, we are more apt to shake our heads, shrug our shoulders apathetically and stay put. May I point out that, in the end, it was ridicule that brought down Tricky Dicky?

A final note: an entire generation has grown up thinking that economics is all about predicting market behaviour. Even very smart people take this view for granted, instead of pausing to ponder what the word economics actually means. But then again, they don't think about what democracy means, either. In the age of economics as market analysis, we call it representative democracy, probably because it merely represents democracy instead of being the real thing.

Warren's Grande Bouffe

2010-06-12T13:00:00.003-04:00

Today, some comic relief.

The price of a lunch with the Oracle of Omaha, also known - appropriately enough - as Warren Buffett, has soared to $2.63 million. All going to charity, of course.

In the chart below we can distinguish three periods for this Grande Bouffe: in 2003 David Einhorn, the famous (some would say infamous) hedge fund manager paid $250,100 for his lunch, a whopping tenfold jump from the previous high of $25,000. Mr. Buffett's days as a cheap date were clearly over.

What's On The Menu?

The price of Lunch (obviously capitalized..) moved briskly upwards after that, reaching over $600,000 in 2007; but it was in 2008 and Mr. Zhao Danyang's whopper $2.11 million that Warren got to be a serious lunch date. Mr. Danyang was yet another fund manager, this time from China (where else..?). I wonder if he got his money's worth? My bet is that the Oracle kept the subjects limited to the menu and See's Candy (yum).

This year's bidder is anonymous. Given the massive unpopularity of financiers these days it's just as well. We don't want voters scandalized any more than absolutely necessary, even if it's for a good cause.

P.S. Do you like the new look?

In Memoriam: Thai McGreivy

2010-06-08T03:01:00.003-04:00

Dr. Thai McGreivy, a regular commenter on this blog, passed away on Sunday night after unexpectedly suffering a massive heart attack the previous Monday.

Thai made many friends here; though I didn't get to meet him face to face, I greatly appreciated and respected his insightful, passionate and often humorous remarks on the issues presented in Sudden Debt. He was my friend.

For me, his enduring legacy will always be fractals, a subject that I was only vaguely familiar with until Thai explained that our world's complex beauty can be best described through the simple elegance of fractal mathematics. He used a picture of the Mandelbrot set as his avatar to keep reminding us of the importance of fractals in everyday life. It wasn't long before I, too, started discovering fractals everywhere, from a bush on the side of the road where I went biking (a passion that we apparently both shared), to persistently similar fluctuations in financial markets. In fact, I was working on a piece called Fractal Finance when I was told of his untimely passing.

But I will always have a much more personal, emotional and lasting appreciation of Thai. You see, some weeks ago I presented fractals to Sofie, the love of my life. Sofie is, among other things, an extremely gifted and talented artist whose paintings are eerily evocative of fractal images. As soon as she saw the infinite sequence of images generated by the simple formula z_n+1 = z_n² + c tears of joy came to her eyes. "I have always known of this deep within me" she said, "I am so happy to see it before my eyes. Thank you so much."

Thank you Thai. We shall always remember you.

An Image Generated From The Mandelbrot Set

Now Hear This: You Are Evicted From Eden

2010-06-02T09:39:00.003-04:00

Homo Economicus is being thrown out of Monetary Eden, a place of previously lush and lazy living on the cheap. Notice of eviction has been posted at 28o44'N 88o23'W (see below).

Deepwater Horizon Burning In The Gulf Of Mexico

What does money have to do with deepwater-rig oil spills, you may ask? Pretty simple, really: fiat money debt relies on Permagrowth to keep the game going, i.e. to provide the near-religious belief that debt is currently serviceable and always repayable in the future. Take Permagrowth away and it all falls apart - unless we manage to give our financial/monetary regime a radical makeover before it's too late.

The fact that we have gone so far as to drill for petroleum (Permagrowth's fuel of choice) in places and ways that guarantee ecological disasters is proof enough that Permagrowth is unsustainable. The same can be said for most other resources, from clean water to basic foodstuffs.

From an engineer's point of view, BP (and most other oil and gas companies) routinely drill for oil in such inhospitable locations, obviously without first guaranteeing the quick resolution of serious emergencies. Is it because they are criminally negligent? No, I honestly don't think so - they aren't that stupid.

The simple answer is they can't. Scarcity of low-hanging-fruit resources means that producers competing for whatever remains MUST cut corners, if they are to bring their products to market at a marginal price that is affordable to an already over-burdened/over-indebted consumer. Let me put it another way: all other things equal, what should be the price of fossil fuels if we were to adequately price in spills? Or climate change? Or geopolitical risk? Or lives lost to "police actions"? Or outright wars?

Bottom line: Our fearless leaders have been injecting trillions of fresh debt into the system to prevent it from collapsing from... too much debt. But the only way to service this debt in perpetuity (once created, all fiat debt is perpetual unless it gets written-off/defaulted) is through Permagrowth. It's like a dog chasing his tail that keeps getting shorter and shorter.

Well, the Louisiana disaster is another reminder that Permagrowth is over and our days in Monetary Heaven are numbered.

(There is a parallel here with the securitization and derivativization of toxic debt: loan originators had to drill very deep into the pool of potential borrowers to come up with "raw material" to manufacture CDOs, CLOs and other such "products". What they came up with stank to high heaven, of course, and since they couldn't afford to adequately guarantee their products it wasn't long before the whole thing collapsed.)

The War Against Finance

2010-05-29T01:50:00.003-04:00

Whilst everyone is understandably worried about Europe'an PIIGS debt, it's also timely to examine what is happening with America's federal government debt, the grand-daddy of them all.

In a word, it's horrible. The debt-to-revenue ratio for the federal government is the highest since right after WWII, soaring to 396% in 2009 and projected to rise further to 424% this year (see chart below).

Data: FRB, US Dept. of Treasury

What is most worrisome is how fast debt rose, literally exploding from 2005 when it stood at $4.7 trillion and 205% of revenue, to nearly $10 trillion in 2010. Such debt dynamics beg for explanations.

Apart from "keynesian" deficit spending, the most glaring dynamic at play is converting debt of the failed financial sector into public debt, i.e. massive bailouts. In 2009 alone, financial sector debt dropped by $1.75 trillion while federal debt increased by $1.44 trillion (see chart below).

Data: FRB

Drawing an analogy with WWII, we the people of the United States went to war against Finance, lost and are now obliged to go deeply into debt in order to pay reparations.

There are a number of logical, if problematic, extensions that can be drawn from this analogy:

Why are we still bailing out Finance? The financial domino theory may be valid, but only during a crisis lasting a few days or weeks, at most. Too big to fail? Fine, but does this still apply to the likes of Morgan or Goldman?
Why are we not demanding our money back? It is insane to provide hundreds of billions to an industry that operates as a set of communicating vessels, taking "bailout" money from the multitudes on one end and giving it out as bonuses to the very few at the other. That's Robin Hood in reverse, with the government's blessing! At the very least, top marginal corporate and payroll tax rates for the entire finance industry should rise to war-time levels (90%).
Why are we still allowing Finance to shoot rockets at us, i.e. to engage in gross speculation for their own account - with our money?
What is the sense of bailing out financial institutions instead of people? Why go into more debt to the tune of trillions (the people's trillions, mind) and - at the same time - have families thrown out of their homes?
Weren't all of us supposed to win in this "war"? Wasn't Finance supposed to be a servant of the Real Economy, instead of its task-master? Because it increasingly looks like Finance is building a bunch of huge forced-labor concentration camps to ring the economy. And guess who the inmates are...?

Financial Overhaul Bill Passes Senate

2010-05-21T09:35:00.001-04:00

The U.S. Senate passes the financial overhaul bill 59-39.

Some four decades ago, one of my worst chores working summers for my dad (he owned the company ) was getting sent to the bank with a bunch of paperwork. Lines, stamps, signatures... endless time wasted. In my school-boy estimation, bankers were amongst the most boring people imaginable - only the head of our accounting department topped them for yawns. But then again, he was a veritable caricature: he wore black satin sleeve protectors and green eye-shades, and his papery-white fingers were always smeared in ink. And he smoked a pipe.

Far better to work down at the factory floor, even though it produced a teenage social disaster; at the end of the day I couldn't get the smell of grease off my hands no matter how hard I scrubbed. Try that with a date. And to top it all off, the pay sucked big time because - according to Dad - the owner's son obviously had to work for free. I even had to work Saturdays. He called it building character, I called it slavery.

But, I digress.

The point I wish to make is that banking was boring, bankers were boring and anyone who wanted to be a banker was bonkers. And that was a good thing.

By contrast, today's bankers and financiers (still) think of themselves as the swashbucklers of the world, moving billions at the press of a button or with a quip of "mine" over a direct phone line. They rarely, if ever, pause to ponder what it is that they actually provide to the real economy, what it is that they produce or even facilitate. The most senior of them may mumble some stock phrase from the Chicago School prayer book, but deep down they know damn well that all they accomplish is to increase total systemic risk for the real economy.

Proof?

Financial engineering, coupled with lax regulation and unquenchable thirst for ever more yield pickup, made it possible to slice and dice obviously crappy loans into tranches and then into bonds and derivatives that were transmuted into AAA assets. And those were further leveraged, both by outright margining them within portfolios and/or by turning them into even more esoteric, higher-order structured products (structural leverage). No wonder the professionals who slapped these products together referred to them as "shitty deals". It didn't matter that some ludicrous math priced them at stunningly low 30 basis points (0.30%) over risk-free Treasuries. When the shitty (deal) hit the fan - as it always does- it was not the bankers who got whacked, but the homeowners, the construction workers, the factory workers, the realtors, the insurance brokers. Most outrageously, the bankers got bailed out and got record bonuses. God's work, my ass.

I could go on, pointing out the complete absence of real economic benefit or merit in activities like: high-frequency/bot trading in shares, 200-1 leveraged FX trading for individuals (also known as bucketshops), financial spread betting (also, also known as bucketshops), index tracker/reverse index tracker ETFs, etc. etc.

But it's Friday once again and I have better things to do. And my hands no longer smell of grease (well, maybe a bit of bicycle grease..).

Debt And GDP

2010-05-17T06:17:00.003-04:00

Lest we forget good old USA amidst all the euro-hand wringing, here's a graph...

Data: FRB and St. Louis Fed

Annual Changes In Total Debt and GDP (Current $)

..and here are two questions:

Where did all this additional debt go (i.e. what was it used for), since it didn't generate appreciable incremental economic activity?
Should we solve this obvious imbalance by reducing GDP (i.e. incomes, jobs, etc.) or by getting rid of debt (through default)?

...and, not so off-topic, in a poll conducted May 6-10 by NBC/WSJ Goldman Sachs has an approval rating amongst Americans of... drumroll... four percent (4%). That's right, 96% of Americans hate their guts (a fast and loose interpretation of the poll, of course). I wonder what it feels like to be so universally despised? God only knows - and he should know, since they are doing His Work, after all? I predict heavy-duty scape-goatism heading their way.

I wouldn't have mentioned it, but their share price is currently scraping lows made last July, when the overall market (S&P 500) was at 875 (it's at 1,127 today). So, is GS underpriced or is SPX overpriced? Hmmm.. as GS goes so does Wall Street?

If The Shoe Fits...

2010-05-16T13:41:00.005-04:00

A dozen alumni from Euro U. Class of 2000, get together for a reunion picnic. The class president, a very thoughtful and generous fellow named Robert, brings everyone a new pair of shoes as a gift: the latest Nike trainer, size 10. Very nice of you, thanks very much... says everyone as boxes are opened and shoes tried on.

But... while Hans is very happy because he's exactly a size 10 and goes jogging all the time - picnics included - Michel is indifferent, since he's a size 10 OK, but spends his spare time at art galleries instead, where running shoes are decidedly declasse. Jorge is size 11 and prefers sand and sandals, Vittorio rarely walks anywhere but when he does he strolls in ultra-thin leather-soled loafers, Lena is a size 4 stilleto club-hopper, Anders has an extra 20 lbs. around his waist and loves fly-fishing in waders... and so on.

To make matters worse, Robert insists that they should now all put their new shoes on and go running together.

Yeah, riiight...mumble the classmates (Hans excepted).. it's true that a decade ago we all promised we would stay trim and fit no matter what, but c'mon dude, get a life already, huh?

P.S. I should point out that there's really nothing much new under the sun (Ecclesiastes 1:9-14, see below). A monetary union was tried in Europe before: the Latin Monetary Union was established in 1865 and fell apart in WWI, though it was formally disbanded only in 1927. Its members? France, Belgium, Italy, Switzerland, Spain and...yes... Greece.

What has been will be again, what has been done will be done again; there is nothing new under the sun. Is there anything of which one can say, "Look! This is something new"? It was here already, long ago; it was here before our time.

The Gimp's Suit

2010-05-14T00:42:00.000-04:00

Well, whaddaya know..? People are finally waking up to the fact that a common currency requires a common fiscal policy (duh). This being (almost) the weekend I don't feel like writing some sort of acerbic diatribe on the euro, so I'll just throw in a joke.

A man decides to finally give in to his wive's constant nagging about his old, ill-fitting clothes and heads to his tailor for a new suit. After a couple of fittings the suit is ready and the man proudly takes it home to try it on for his missus.

"Oh dear", says she. "Can't you see the left pant leg is too short?"

The man goes back to his tailor. "Eh.. just lift your leg a tiny bit and it will look OK. No sense ripping the whole thing up, no?" says the tailor. The man tries the trick and goes back to his wife.

"OK, fine... but, wait a minute, the right jacket sleeve looks too long. Take it back to the tailor." The crafty tailor, predictably enough, tells the man to just stretch his hand out a bit.. To make a long story short, a bunch of neeeded alterations are circumvented by the tailor's advice to crane his neck, throw his hip out a bit, puff his chect, etc.

As the man walks out of his tailor's shop wearing his badly-tailored suit and trying all the tricks to make the suit "fit", a street urchin takes a good look at him and cries out: "Hey wow!.. Ain't that a fine suit the gimp's wearing?"

Have a nice weekend... (and if you think that a bunch of europeans will sit down and agree on a common fiscal policy, I have a suit for you. Cheap.)

Fifi's World, A Monetary Allegory - Part II

2010-05-11T00:37:00.002-04:00

As Fifi's father listened, the stranger told him to chuck everything he was told about his daughter's illness by the so-called experts. It was obvious that Fifi was not suffering from a simple cold, but that she had a bad case of walking pneumonia and, therefore, no matter how much aspirin she took the illness would persist and continue to worsen. The parents should immediately renounce More Is Better and concentrate, instead, on fewer but much more effective rememedies, such as a course of antibiotics and a healthy diet.

The stranger also insisted that a radical shift in lifestyle was very important, once Fifi was healthy again. Exercise, outdoor activities and the like were very important, if Fifi's family wanted to get healthy and stay healthy.

Fifi's father didn't even bother to think about the stanger's propositions. It was more than obvious that he was a quack, a mendicant - perhaps even a raving lunatic. Everything he said was a blasphemy against the official religion, an abomination before FIAT. He slammed down the phone without a word, More angry that a total stranger would have the temerity to approach his family with such nonsense when Fifi's life was in More danger.

What became of Fifi herself we do not know. Moreover, we are in the dark about her family and all other families in Fifi's world because, soon thereafter, the illness spread and wiped out everyone.
-------------------------------------------------------

We now shift from Fifi's world to our own.

The Earth is obviously reaching its carrying capacity under present conditions of science and technology. We cannot expect to feed, clothe and coddle another 3-4 billion human beings - Chinese, Indians, Africans - to the level accustomed by us westerners, or even near-westerners. Natural and environmental resources are depleting fast and, unless we immediately discover another nearly-unlimited, higly concentrated and non-polluting energy source, we urgently need to:

Revamp our socio-economic system to Sustainability and just as importantly,
Adopt a monetary system to match.

Quite obviously, an unbounded, unlimited fiat currency monetary system is hugely at odds with a bounded economy, i.e. an economy where growth is severely constrained by the hard boundaries of resource depletion and environmental degradation.

The dollar, euro, yen, yuan... they are all based on Permagrowth, the once simple but today simplistic premise that debts incurred today will always be serviced tommorrow - and ad infinitum - by an ever-expanding global economy.

We have, as of last Sunday, played our last global FIAT card: the EU has gone all-in in the credit bubble game when it announced it will set up a $1 trillion special purpose vehicle to issue Yet More Debt to shore up the clearly bankrupt PIIGS economies and the banks that financed them (and everyone else, the UK included). More debt, to solve the problem of too-much-debt...

Bottom line: Bretton Woods is deader than a doornail, yet we are embarking on a last vainglorious attempt to prove it is still alive and kicking. It will cost us dearly.

I feel like Fifi..

Fifi Fiat, A Monetary Allegory - Part I

2010-05-10T04:39:00.007-04:00

Some weeks ago Mr. and Mrs. Fiat's young daughter Fifi fell ill. She sneezed and she caughed and she ran a slight temperature, but her parents were not overly concerned. After all, it was normal for children her age to catch colds and other mild viruses at school. It will go away soon on its own, they reasonably reasoned.

But Fifi kept getting worse and her parents soon started worrying.

Let's pause for a minute to examine Fifi's world. Some seventy years ago a new religion became all the rage throughout the nations and everyone converted to a new god they called FIAT. According to the high priests, it was His wish that everyone should adopt the last name Fiat and their children be given four-letter first names constructed of just two letters, "f" and "i". This simplistic approach to the needs of individuals quickly lead to names like Iffi, Ifif, Fiif and, of course, Fifi, thus making it difficult to distiguish between persons and leading to all sorts of practical difficulties. But no matter, religions are, by definition, at least partly irrational and FIATism was no exception.

One of the basic tenets of the new religion was More Is Better, which sharply distinguished it from the previous official religion which preached that Better Is Best. No wonder, then, that FIAT quickly became such a popular god. Why toil and scrape to make a Better Whatever, when one could simply have More?, ran the argument. This philosophy permeated every aspect of life - medicine included, unfortunately for poor Fifi as we shall soon see.

For as Fifi's illness steadily grew worse her parents simply kept plying her with more aspirin, more cold compresses and, of course, more of her usual diet of ready-made fatty foods and sugary drinks. The family doctor recommended a specialist who, having been properly consulted and pocketed his More Hefty fee, nodded his head sagely and prescribed.. More Of More!

But it didn't work. Mr. and Mrs. Fiat were soon scared for Fifi's life and, since medical science did not work, they turned to religion. Candles, incense, genuflections and alms were all generously offered at the altar of FIAT. And then, of course, More candles, More incense, More genuflections and More alms...

But nothing worked. Fifi just got worse. More worse, as Mrs. Fiat wryly remarked late one night, when desperation got the best of her.

One evening Mr. Fiat got a phone call from a stranger. "I hear your child is sick and nothing you have tried is working", said the stranger. "I can help, but you must be willing to listen with an open mind." Fifi's father had nothing to lose so he let the man go on.

To be continued..

Gorillas In The Drawing Room

2010-05-07T01:22:00.008-04:00

One of these days the entire world is going to wake up and realize that its debt problems are one heck of a lot bigger and more serious than Greece, which is just the first Debtopia to unravel. That it's not the debts of Portugal, Ireland, or even Spain that may cause the entire post-WWII financial system to come crashing down.

But that it is the United States, with a total debt load of $53 trillion (380% of GDP) and monstrous unfunded medical and pension liabilities (pick a BIG number, it's all quite fictional anyway), that is the huge gorilla in the drawing room that everyone is studiously trying to ignore.

Financial panics are not created in a vacuum; they are born from a mixture of high leverage, overvaluation and serious negative economic developments that simmer underneath, while complacency drives prices ever upward until there is nothing below to support them. And when the inevitable aha! - ohoh! - oh shit! - what the f*ck?! - moment arrives everyone wants to jump off the trapeze at the same time, only to discover that the safety net that is composed entirely of "faith" is gone.

One of these days people will panic, start selling into a hollow market that has no bids at all, take out sell stops in one fell swoop and force the cavalry to come to the rescue, later claiming that the plunge was - perhaps - some sort of a technical glitch.

It looks to me, then, that yesterday was a dress rehearsal for a bona fide panic, even if it was exacerbated by the prevalence of automated electronic trading in non-traditional venues (i.e. outside of NYSE and NASDAQ) where liquidity suddenly disappeared (and why did liquidity suddenly disappear?). Some will point fingers to such black-box trades in order to explain away the sudden plunge in prices, but my experience tells me it was otherwise.

(Here's a piece of information that may explain massively abrupt declines: thirty or forty years ago most shares were owned directly by individuals. Today this figure has shrunk to around 20%, the rest controlled by professional money managers who, playing with Other Peoples' Money, mostly follow the same play-book.)

The real cause, in my opinion, is the same as a year or two ago: there's just too much debt in the system. Governments and central banks took unto themselves the toxic and defaulted debt of the private sector (mostly financial), but the entire debt is still there - albeit in different form. It was, therefore, only a question of when and where its crushing weight would make itself felt once again.

Let me put it this way: we have painted the gorilla to match the curtains in an attempt to make him almost invisible to those willing to be fooled. But that doesn't mean he's not there.
____________________________________________________

Something totally unrelated, I just couldn't resist. Or, maybe, it isn't unrelated? The UK is about to have its first hung Parliament in 35 years.

The following picture is from yesterday's UK elections. David Cameron, leader of the Tories (Conservatives) is at the podium, presumably giving a thank-you speech for being re-elected to his seat in Parliament.

Now, who's the guy behind him? And... they call it the Conservative party? OOOOkkkkkkk...

Photo: NY Times

Pizza Delivery, Anyone?

2010-05-04T00:48:00.009-04:00

The following anonymous email is making the rounds (It's in FT Alphaville).

“We are Wall Street. It’s our job to make money. Whether it’s a commodity, stock, bond, or some hypothetical piece of fake paper, it doesn’t matter. We would trade baseball cards if it were profitable. I didn’t hear America complaining when the market was roaring to 14,000 and everyone’s 401k doubled every 3 years. Just like gambling, its not a problem until you lose. I’ve never heard of anyone going to Gamblers Anonymous because they won too much in Vegas.

Well now the market crapped out, and even though it has come back somewhat, the government and the average Joes are still looking for a scapegoat. God knows there has to be one for everything. Well, here we are.

Go ahead and continue to take us down, but you’re only going to hurt yourselves. What’s going to happen when we can’t find jobs on the Street anymore? Guess what: We’re going to take yours. We get up at 5am & work till 10pm or later. We’re used to not getting up to pee when we have a position. We don’t take an hour or more for a lunch break. We don’t demand a union. We don’t retire at 50 with a pension. We eat what we kill, and when the only thing left to eat is on your dinner plates, we’ll eat that.

For years teachers and other unionized labor have had us fooled. We were too busy working to notice. Do you really think that we are incapable of teaching 3rd graders and doing landscaping? We’re going to take your cushy jobs with tenure and 4 months off a year and whine just like you that we are so-o-o-o underpaid for building the youth of America. Say goodbye to your overtime and double time and a half. I’ll be hitting grounders to the high school baseball team for $5k extra a summer, thank you very much.

So now that we’re going to be making $85k a year without upside, Joe Mainstreet is going to have his revenge, right? Wrong! Guess what: we’re going to stop buying the new 80k car, we aren’t going to leave the 35 percent tip at our business dinners anymore. No more free rides on our backs. We’re going to landscape our own back yards, wash our cars with a garden hose in our driveways. Our money was your money. You spent it. When our money dries up, so does yours.

The difference is, you lived off of it, we rejoiced in it. The Obama administration and the Democratic National Committee might get their way and knock us off the top of the pyramid, but it’s really going to hurt like hell for them when our fat a**es land directly on the middle class of America and knock them to the bottom.

We aren’t dinosaurs. We are smarter and more vicious than that, and we are going to survive. The question is, now that Obama & his administration are making Joe Mainstreet our food supply…will he? and will they?”

Whoever wrote this truly believes that the years he/she spent trading sardines in front of a bank of flat screens has prepared him/her for the real economy. What's more, he thinks he/she is "smarter and more vicious".. Well, I'll definitely grant him/her "more assinine" - but, "smarter"?

Yo, dude.. wake up. Do you really think anyone will hire you to teach third graders? With an attitude like that? I can just picture you strutting into the primary education office in Smallville, smirking like a Master Of The Universe. Your oh-I'm-so-understated Barneys chinos alone will scream "I've been eating your lunch" to the lady behind the desk, who could only afford chinese crap from WalMart since god knows when. Let me put it another way: do you want someone like you teaching your kids? Oh boy, are you in for a real world comedown.

What you haven't figured out yet is that you are the roadkill here, that you are confusing brains with a bull market. Maybe you can get a job delivering pizza, but I seriously doubt it. You probably don't have enough pimples and your teeth are definitely way too straight and white. Maybe you should have saved the good-times money, instead of throwing it to the skin specialist and the orthodontist, eh? Now, that would have been a heck of a lot smarter. And you wouldn't ever have to ponder hitting grounders for summertime peanuts.

OK, one last thing, since you mentioned dinosaurs.

It's the Jurassic, it's been raining a lot and there is a sh*t-load of yummy giant ferns around. So, you've been feasting and gorging, ultimately becoming a huge plant-eating brontosaurus. And then, this Big-Ass Mama From The Sky slams into Earth and turns your world into the Gulf of Mexico. You survive, but the dust cloud is killing most of your food.

And what do you decide to do? Size-down and search for smaller ferns someplace else. Bad decision, there are way too many of you and too few ferns. That makes you a loser, lizard, and you said so yourself. Because true winners fight like hell to always stay at the top of the food-chain pyramid. Like, adapt and turn carnivore - velociraptor?

Dude, you're my very own walking bronto-burger. Yum.

On Greek CDS

2010-04-30T03:05:00.003-04:00

Under the efficient market theory the following trade should not be possible, yet you can put it on right now:

Buy 5-year Greek Government bonds (rated BB+) to yield 11.2% and,
Buy a 5-year CDS on the same Greek Government bonds at 620 bp (6.2% per year) from, say, Deutsche Bank (rated A+).

The net result is you make 500 bp (5%) net profit per year (11.2% - 6.2%) for up to five years and, at the same time, lower your credit risk very substantially, since Deutche Bank is rated six whole notches higher than the sovereign risk of Greece. If Greece defaults you just deliver the bonds to Deutsche, get 100 cents on the euro and walk away.

Execution of the actual trade may result in somewhat different numbers since bid-offer spreads are very wide right now, but the arbitrage window is, nonetheless, enormous.

What gives?

Note: German Government 5-year bonds (schatz) yield 2% and those issued by Deutsche yield 3%.

Petunias In The Park

2010-04-29T02:41:00.000-04:00

“In many local communities, fountains are not switched on and flowers are not planted in the public parks because of a lack of money,” said Andreas Blätte, a political science professor at the University of Duisburg-Essen in the state of North Rhine-Westphalia, explaining why so many Germans oppose lending money to Greece.

Hold the presses. Germans can't afford petunias in the park and, thus, are willing to chuck European solidarity and integration into the compost heap of history.

Revealed At Last: The Missing Link To European Monetary Integration

Helloooooo? Wake up Germany, this is the most important test ever of the euro as a major global reserve currency and, therefore, the EU's prospects for becoming a real player in the balance of power game.

Unless, of course, the vision is to shrink the eurozone to an uber-alles core of Germany, Holland and Austria by ejecting the "weak" South and other such untermenschen from the club. If this is the plan and your euro becomes so strong vs. their drachmas, lire or pesetas... who's going to buy your products? Surely not the Chinese, so we'll see then what productivity is all about, eh?

Figure it out: Alles cannot be in ordnung all the time within a Union of so many different and disparate members. The skills necessary for the Union's leaders are flexibility, diplomacy, a willingness to cut deals in back rooms and (gulp) a certain amount of charm. Come to think of it, maybe you should leave the job to the Italians.

Is A Greek Default Inevitable?

2010-04-28T02:22:00.003-04:00

No, it isn't. But it may very well be desirable for all concerned, up to a point.

There are two extreme possibilities in resolving the Greek debt crisis:

Plan A: Massive default with near zero recovery for creditors and exit from the eurozone.
Plan C: Massive Greek fiscal adjustment with murderous wage, pension and public service cuts, plus tax hikes.

Plan A puts the entire workout cost on the shoulders of lenders. Most of them are foreign banks that have posted their holdings as collateral with the ECB, and various public pension funds. This makes Case A politically and strategically untenable, as lenders would then try to seize Greek financial and physical assets wherever and whenever they find them, freeze trade and generally bring unbearable pressure to bear. ECB's balance sheet would take a huge blow and the euro could fall apart.

Plan C places the entire burden on the Greek economy. This may seem fair at first. After all, it was Greeks who borrowed with abandon and squandered the money on overpriced houses, Olympic Games and a hugely bloated public sector. Not to mention a thoroughly corrupt cleptocratic political system that is constantly in bed with a private sector that no longer produces much of anything at globally competitive prices.

And yet.. it was foreign lenders who made all this possible, even though they knew - or should definitely have known - what was going on in Greece. For example, it was foreign banks that kept buying Greek bonds at a ridiculously tiny spread of 30 bp (0.30%) over German bunds for years because they could post them as "cheap" collateral at the ECB. What happened to their fiduciary responsibility? It went out the window - the same window that allowed for the manufacture of poisonous AAA synthetic CDOs from CCC subprime mortgages. It is ludicrous that such irresponsible practices should be rewarded post facto and their practitioners be made whole.

Therefore, I call for implementing Plan B, a solution obviously in-between A and C.

Plan B: Share the blame and the cost, but not necessarily 50-50.

My proposal (though obviously not my opening gambit at the inevitable bargaining table) would be to pay creditors a net present value of 65-70 cents on the euro through a combination of maturity extentions, lower coupons and outright principal reductions. At the same time, I would demand the Greek government to implement at long last serious tax, pensions and public sector reforms in order to immediately (i.e. 2011) produce primary budget surpluses.

As part of the bargain I would also like to see all EU or eurozone countries exercise their right of eminent domain over their sovereign bond credit default swap contracts (CDS). To wit, I would require all such contracts agreed under EU laws, or between parties domiciled in the EU, or their subsidiaries wherever domiciled, to be settled in case of default or other credit event, only by tendering the relevant bonds. This would include all present and future CDS contracts.

In other words, all should share in the pain because all share the blame of creating and sustaining the debt bubble.
__________________________________________________________________________

Greek Debt Watch: 5-year CDS currently at 850 bp; implies CPD of 72% if recovery is assumed at 65%

The Lineup

2010-04-27T11:49:00.001-04:00

I don't know why, but the following picture from Reuters strikes me as hilarious. It must be the fact that these guys are all being sworn to tell the truth. Uh-huh..

From The Goldman Sachs Congressional Testimony

Oh, and notice the IDENTICAL 6-inch thick binders in front of each. Words fail me, but what need have we of words when pictures speak so eloquently.

PS Think the guy on the right is a Trekkie?

The End Of Debtopia

2010-04-23T05:19:00.008-04:00

April 26, Monday morning update: Greek 5-year CDS reaches 700 pts. (see chart below). Assuming a 67% recovery, this works out to a cumulative probability of default (CPD) of 67%. At 80% recovery, CPD rises to 82%. These are daunting odds, indeed, and mean that Greece will not likely avoid some sort of "credit event".

Two-year Greek government bonds are quoted 86-87 to yield 12.4%, meaning that the bond market is already pricing in a significant part of such an eventuality.

Chart: CMA

______________________________________________________________________________

Greece is turning into history's first failed debtopia, an economy that thoroughly eviscerated its production and earned income foundations to replace them with consumer spending on cheap imported goods and asset inflation, both fuelled by massive foreign debt. Naturally, GDP growth kept zipping ahead for a while, but so what? To arbitrarily extend the ketchup economics of Larry Summers, Greeks shut down all of their tomato-processing factories, borrowed a ton of foreign money to turn factories and farmland into expensive condos and bought cheap imported ketchup, instead. Naturally, there were lots of domestic jobs in home construction at first, but as soon as credit conditions turned sour it was game over.

Greeks no longer make anything that anyone else wants to buy at the price Greeks demand (see chart below), cannot earn enough money to service their debt properly and - quite obviously - cannot maintain a lifestyle that rose to unsustainable levels because of that ever-higher debt. Furthermore, they cannot devalue their currency to increase competitiveness and inflate their way out of debt. Their only choice is domestic deflation and even the head of IMF has pointed this out: "The only effective remedy that remains is deflation" he said a few days ago.

Table: Eurostat 2009 Yearbook

Greek Labour Productivity Extremely Low

Of course, what Mr. Strauss-Kahn means when he says "deflation" is fresh loans in exchange for a reduction in the domestic cost of production, i.e. lowering workers' wages and benefits, plus a healthy dose of deregulation. In other words, the standard IMF medicine administered many times with dubious results (think Argentina).

Quite apart from the obvious retort of "lower the cost of making what?", since the Greeks no longer make ketchup, I fear that the IMF's plan for Greece will prove an utter failure, at least as it is envisioned right now. While I agree that deflation is absolutely necessary, since being a member of the eurozone Greece cannot perform a competitive currency devaluation, I strongly disagree with the type of deflation that is needed. To wit, I would recommend debt and asset deflation, to bring fixed costs in line with what the economy can earn.

For example, residential and commercial real estate prices should come down enough so that wages and business earnings may once again comfortably cover its purchase or rent. Right now they don't, and by a wide margin (e.g. an apartment in Athens can cost several times more than the average single-family house in the U.S.). Similarly, the country's total debt load should be reduced - instead of increased with more loans from the EU or IMF - to a level where it can be serviced properly by the real economy.

And as an aside maybe I should point out the debtopic similarities between Greece and the United States? Ah, but the U.S. has its own currency and can devalue at will, you may retort. Can it, really?

Most Likely Scenario For Greek Debt Crisis

2010-04-20T04:51:00.010-04:00

I will hazard a prediction: The most likely resolution of the Greek debt crisis is a combination of debt restructuring (haircut plus maturity extensions) and IMF/EU funding for the next 2-3 years.

Before I get accused of becoming a prophet in my old-blog age, I hasten to clarify that this is what the market is already predicting: the 4.60% Greek Government Bond due 9/2040 is currently trading at 68-69 (YTM = 7.20%), i.e. at something less than 70 cents on the dollar. This is a spread over the nearest equivalent German bonds of 334 basis points. By contrast, the shorter 6.25% GGB due 2020 is trading at 89-90 (YTM=7.75%), a spread of 467 bp over Bunds. Notes coming due in two to seven years are trading at even wider spreads - see the chart below.

Front-end Of Greek Government Bonds Trading At Much Bigger Spreads Over Germany

I expect, therefore, a voluntary debt swap i.e. swapping bonds coming due over then next 5-10 years for longer maturities, maybe with a self-amortization feature, along with the IMF/EU funding package. The voluntary feature will likely be there to avoid triggering a credit event under CDS terms, but if structured properly most everyone would want or have to participate - a.k.a. a shotgun marriage.

For example..

Concurrently, the Greek government could enact more revenue-enhancement measures (that's what new taxes are called, in beffuddle-the-masses speak), probably a real estate ownership tax. Such a tax could easily raise 5 billion euro/year (current debt service runs at 12-13 billion/yr) and, crucially in a country where tax avoidance is the national sport, would be nearly impossible to avoid.

Take that tax money, segragate it into a special account administered by a Paris Club-type of group, earmark it for the sole benefit of those accepting the debt swap with first-lien bonds and voila..

The key element in such a deal will be to structure it in such a way as to minimize immediate stress in the balance sheets of major Greek debt holders, i.e. foreign and domestic banks, plus pension funds. Given the generously stretchy accounting rules for banks holding sovereign debt, it shouldn't be too difficult.

P.S. I looked at the numbers before I came up with the "..most likely" part of the post's title. Playing around with the Cumulative Probability of Default (CPD) formula, we can evaluate various scenaria of recovery rates (i.e. how much the "haircut" will be in a potential debt restructuring). If we assume a generous 80% recovery (20% haircut) current CDS prices of 500 bp indicate a CPD around 60%. And, in fact, most Greek government bonds already trade around 70-85 cents on the dollar, depending on maturity and coupon.

I don't think Greece will bother to go through a painful debt restructuring process unless it can significantly reduce its debt load, say at least down to 80% of GDP from a projected 120% at the end of 2010. This implies a haircut of approx. 33% (recovery of 67%). Plugging in these numbers to the CPD formula (r=67%, CDS=500) we get a 5-year cumulative probability of default of 55%.

UPDATE: Five year CDS now trading around 650 bp, implying a CPD of 62% at 67% recovery.

Oldie But Goldie

2010-04-19T05:33:00.001-04:00

Well, well... Turns out that Goldie wasn't "doing God's work" after all. The SEC has just charged the world's biggest investment bank with defrauding investors in a sub-prime mortgage synthetic CDO (i.e. a virtual bond made up of credit default swaps).

I will spare you repetition of details - readers of this blog being a well-informed crowd - and just share a Wall Street joke of old, applicable to this situation.

A broker invites his customer - the manager of a large pension fund - to a dinner meeting of Wall Street big shots. They arrive together at the fancy restaurant promptly at 7.30 pm and, as they make their way towards the private dining room in the rear, the broker confides to his customer - sotto voce, of course - that amongst those attending the function tonight will be a wold-class sucker, a schmuck whose perennially misguided investment decisions provide untold millions in profits for all the rest.

As the customer makes the rounds during the pre-dinner cocktail hour he stares at the attendees, trying to identify the "mark": "That's Lloyd, certainly no sucker.. and that's Ken, certainly no fool.. and there's Bill, a really sharp guy".

After a while, the customer gives up shaking his head. "Oh well, I guess he never made it to this dinner", he says as he heads to the bar for one more drink.

P.S. Given that structured finance hanky-banky has certainly occurred at many other financial institutions, it is very interesting that for its first serious action after the meltdown SEC is going after Golman, Wall Street's most emblematic firm. It could be a sign of seriousness, or it could just be political smoke. We will just have to wait..

Suspension Of Debtbelief

2010-04-16T07:46:00.002-04:00

I have been a close observer of the Greek Debt Crisis for quite some time now. What strikes me most is the absurdity of calling for additional debt as a solution. It's not enough that Greece already has a government debt rapidly approaching 120% of GDP and cannot realistically fund itself through the markets, its government, the EU and the IMF are proposing that it takes on even more debt, albeit at lower-than-market interest rates, as a way out of its already untenable situation.

Let's go back a few years to the height of the debt bubble when Greece - already over-indebted at 100% of GDP - could sell 10-year government bonds at a mere 25 basis points (0.25%) over Germany (the spread is now 400 bp). I maintain that this required a suspension of disbelief equivalent to observing Harry Potter ride a broomstick over the skies of Hogwarts on the silver screen and accepting it as fact, i.e. total immersion into fiction-as-reality. Park your brains at the popcorn stand, sit back at the comfy chair, sip the kool-aid and enjoy while the movie lasts.

What, me worry? was the attitute. New Age Credit was flowing freely, whilst risk was supposedly being taken care of by newfangled instruments devised by the apprentice financial engineer-magicians.

Well, guess what folks? The movie's over. Suspension of disbelief is over. What's going on right now, best exemplified by the preparation of Greece to tap the IMF and EU for even more debt, it's like those folks who stubbornly refuse to leave their seats staring forlonly as the credits roll over the black screen, hoping to eke just a smidgeon more of happy times.

We all need a radical reality check, to understand that our kool-aid was heavily spiked with debt acid. That for a while we lived in a make-believe world where we acquired goods and services with a mere scrawl at the bottom of promisory notes that someone else - obviously dropping even heavier acid - accepted as prima facie "assets".

In other words, we need to suspend our "debtbelief", that debt is a panacea for all economic ills from stagnant earned income to a minuscule savings rate and the emasculation of the western manufacturing and technological base.