Saturday, October 31, 2009

A More "Personal" Look At Debt

It is common enough to look at debt as a percentage of GDP, DPI, etc. but that's so... impersonal. So here are a couple of (very scary) charts that look at things from a dollars per person perspective (click on charts to enlarge).
  • Debt per person and GDP per person.

  • Debt per person and Disposable Personal Income per person.

Note: the Total Debt used to construct these chart does NOT include debt of the financial sector so as to avoid any double counting (e.g. a mortgage inside a CDO), even at the cost of somewhat understating the crush of debt. It's bad enough, anyway..

Thursday, October 29, 2009

Boundary Conditions

A reader asked if I think the yield curve will flatten. The answer is yes, I do.

A steeply positive yield curve - as it is now - is the bond market's way of discounting a sharp rebound in the economy; I believe this optimism is unfounded and will soon be proven wrong, leading to a reversal. Sketching the picture in very broad lines, declining consumer spending (70% of GDP) will be the most serious drag on the US economy, due to persistently high and rising unemployment.

Let's look at the curve itself (see chart below).

US Treasury Yield Curve

The next chart shows the spread, or difference, between interest rates for 10-year Treasury bonds and 3-month bills since 1953. Currently the rates are 3.47% and 0.07% respectively, resulting in a spread of 3.40%, or 340 basis points (a basis point is 0.01%). That's very high by historical standards (see chart below, click to enlarge).

Data: FRB St. Louis

Next, I perform a frequency analysis for this spread and produce the following histogram (click to enlarge).

In the last 45 years the spread averaged 139 bp with a standard deviation of 119 bp. Quite obviously, the vast majority of the values are positive (above zero), since inverted yield curves are rare.

The charts above, however, do not tell the whole story because they track the difference in rates without taking into consideration their absolute levels. Because nominal interest rates cannot go below zero, it makes a whole lot of difference if a spread of 340 b.p. is the result of 6.40% minus 3.00% or 3.50% minus 0.10%. These two situations describe completely different economic and financial market conditions, even if the spread is exactly the same. So, we need to look at the spread from another perspective.

  • Let's chart the spread as a ratio of the 10-year bond rate, i.e. take the spread and divide by the 10-year rate at any point in time. This provides a better sense of how wide the spread is in relation to the absolute level of interest rates.
The spread is now 96.5% of the 10-year yield (3.40/3.47= 0.965), i.e. a person by putting his/her money in 3-month bills is giving up almost the entire return possible from a longer-term bond. That's quite extreme and unprecedented in the last 45 years (see chart below, click to enlarge). The average over the same period is 25% and the standard deviation is 22%, i.e. the current ratio is in +3σ plus territory.

In a previous post (Bills And Swaps Indicate Great Optimism) I said that such low rates for Treasury bills (plus other indicators such as forward rate swaps) are the result of the Street's optimism. Speculators think the economy is bouncing back, bringing inflation, higher interest rates and lower bond prices with it. Therefore, they are piling into the shortest possible investments in order to shorten portfolio duration and avoid market value losses.

But, we have now demonstrably approached boundary conditions: T-bill rates are essentially zero, meaning that most speculators are 100% certain of the optimistic scenario. The only thing certain being that there are no certainties, I am more comfortable taking the opposite view, i.e. that the economy will weaken again and that the curve will flatten.
Addition by special request (Greenie): The 10y-3m spread for 1931-1952.

The spread between 1931 and 1952

GDP Addendum
Third quarter GDP came in at +3.5% (real, seasonally adjusted, annualized), as usual "higher than expected". Crunching through the full set of numbers we can immediately distill the whole report to the following:
  • Cash for clunkers accounted for 1.7%, i.e. half of the increase.
  • Inventory adjustments (lower liquidation of goods in stock) accounted for another 1%.
In other words, 80% of this "growth": (a) came from a temporary government boost that is already gone (see chart below), or (b) was essentially technical in nature.

Wednesday, October 28, 2009

Lies And Headli(n)es

Today's release of durable goods orders numbers for September was greeted by the following headline over at Bloomberg: US Durable Goods Orders Rise Fourth Time in Six Months in Recovery Sign.

OK, so what are the numbers? Orders increased by a seasonally adjusted 1% from August - not exactly a bonanza, but OK in these hard times - one would think. Not so fast..
  • First of all, August numbers were revised down from -2.4% to -2.6%, so the rise is smaller than it seems.
  • Secondly, only two categories accounted for the entire $1.61 billion increase in orders: machinery with a gain of $1.7 billion (+7.9%) and defense aircraft with $618 million. (+12.5%).
  • Just about everything else was down for the month: civilian aircraft (-2.1%), motor vehicles (-0.1%), computers and electronics (-0.2%), electrical equipment (-0.9%), all others (-1.4%). Metals were flat (+0.09%).
Looking at the two positive categories: machinery orders year-to-date are down a steep 29% vs. 2008, even after last month's rise. So, it's not surprising to see a blip up; things like machine tools do wear out. As for defense aircraft... two wars says it all.

After all that is considered, I think the headline is a bit misleading, won't you say?

Friday, October 23, 2009

The Fisher-Bernanke Snake Oil

Everyone agrees we are going through a Great Recession brought about by excessive debt; or, to be more precise, the deflation of excessive debt. The proximate cause of the crisis is, therefore, similar to that of the Great Depression during which Yale economist Irving Fisher wrote The Debt Deflation Theory Of Great Depressions (1933).

Mr. Fisher became justly infamous for his supremely ill-timed prediction of permanently high share prices just days before the Crash of 1929. What is less well known about him is that he lost his fortune in the Depression; not because he speculated heavily before the Crash, but because he kept buying all the way down afterwards and eventually had to be bailed out by his wealthy in-laws.

Well, as the saying goes, a recession is when your neighbour loses his money and a depression is when you lose your own, so it doesn't surprise me that Mr. Fisher finally "got religion" about debt's corrosive powers in 1933, four full years after the Crash.

Despite his claim of breaking new ground with his above study, the conclusion that over-indebtedness leads to liquidation, distress selling, a fall in the level of prices, unemployment and economic malaise was, in fact, very very old hat. Think of the Sumerians (5000 BC) and organized agriculture, spot and forward grain markets, loans of silver, the Code of Hammurabi fixing interest rates to avoid usury, etc.

Mesopotamian Contract For A Three-Month Loan Of Silver (1800 BC)

In any case, Mr. Fisher eventually figured out the cause of the Great Depression. Bravo, but what does that have to do with today's troubles? Enter Mr. Bernanke..

The current Fed chairman - himself an academic theorist from Princeton - is a great fan of the late Yale don and his remedies for debt-deflation depressions. Here is a revealing paragraph from Mr. Fisher's 1933 opus:

"... It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

In other words, Mr. Fisher claimed that depressions could be prevented, or remedied once they were under way, "simply" with monetary policy. I strongly believe this to be utter nonsense.

The main reason is this: the production, distribution and consumption of real goods and services cannot be ultimately controlled by an artificially imposed mechanism such as money, which is, after all, a measurement and exchange convention. Claiming that money controls the real economy is like saying that how far we travel depends on how many miles we make available to measure distance with. Or, as a friend is fond of saying: "It's only money".

(In Mr. Fisher's defence, however, I must also note that he probably couldn't in 1933 imagine a currency regime so completely devoid of reality anchors; i.e. today's purely fiat money, which can be issued at will by the mere act of borrowing. Neither would he conceive of authorities so narrow-minded, so perniciously attached to free market dogma, that they would completely disavow their legally mandated regulatory and oversight responsibilities.)

My position is that the massive debt bubble created a similarly massive amount of malinvestment in surplus (and now useless) physical stock: housing, ships, office buildings, shopping centers, factories in China, call centers in India, vacation homes in Spain, and much more. Excess capacity is a common enough phenomenon of all run-of-the-mill recessions, being the result of fallible human beings optimistically extrapolating demand too far out of reality's reach. Usually, it is soon absorbed after a few quarters of creative destruction and increased demand from a rising population.

But this time it's different - very different - precisely because the huge global credit bubble blew this extrapolation, this excess capacity creation, way out of all previous experience. For example:
  • Between 2000 and 2008 there were a total of 14.8 million new housing units completed in the U.S., versus the formation of only 5.7 million new households.
  • Orders for new dry bulk ships and tankers zoomed, so that deliveries are scheduled to reach a combined 1,700 vessels in 2010 and 1,400 in 2011, versus 734 this year.
  • In Dubai 3 million square meters of additional new office space is to be completed by 2011, versus 3.25 sq. mts. in existence today.
  • In Spain, I saw with my own eyes hundreds of new "luxury" multi-unit vacation home developments, sprouting like mushrooms along the coast from Gibraltar to Almeria and further. One of them was, incredibly, located right around a polluting cement factory and the coal-fired power station of (aptly-named) Carboneras.
No, this is not my daddy's recession, not even my grand-dad's, and I claim as obvious that this type of excess cannot be remedied by monetary policy alone, as Messrs. Bernanke and Geithner (and Mr. Paulson before him), plus an army of financier-speculators now believe. They are acting much like voodoo medicine-men, applying ancient patent snake oil on a malady that instead requires a radically different and up-to-date treatment.

What needs to be done? I have laid out my proposals several times, so I will only provide the headlines here:
  1. Straight debt cancellation for a portion of debt, particularly for the "bottom" 80% of the population.
  2. Anchor the dollar and money supply to the real Green/Sustainable economy via The Greenback.
  3. Focus government action on income creation, instead of asset/credit/debt protection.
Have a nice weekend.

Tuesday, October 20, 2009

Bills And Swaps Indicate Great Optimism

The US Treasury auctioned three and six month bills yesterday. Interest rates came in at 0.08% and 0.17% respectively (these are annual rates) and demand was very strong; the bid/cover ratio was around 4x. Apart from this and the previous two auctions, such bill rates were last seen in the depths of the Great Depression. One could be tempted to interpret this as flight to safety, fear of the credit crisis, etc. But it's not that at all - in fact, it's the exact opposite.

T-Bill Rates Near Zero

Investors and speculators are now so convinced that the economy will rebound strongly in the very near future, and therefore rates will rise, that they want to stay as short as possible duration-wise in their bond portfolios. Thus, they fall all over themselves to bid and buy the shortest possible paper available, i.e. T-bills. The same bullish consensus has also gripped Europe, where similar instruments are going for 0.40-0.50% (ECB's official rates are slightly higher than the Fed's, 1% vs. 0.25%).

Among other things, such almost-zero bill rates serve as a bullish sentiment indicator. People are willing to accept a near zero return now, in order avoid losses when rates go up (bond prices drop as the economy grows and rates rise).

Another indicator is the spread between current rates for longer-term instruments and their forwards. For example, 10 year interest rate swaps (IRS) are trading at 3.54% in the spot market, whereas their one year forwards are at 4.00% and two years at 4.32%. This means that speculators expect 10-year rates to be significantly higher two years from now. The spot-2 year spread for 10 year IRS is currently at 78 basis points, very near its record high (see chart below).

10-Year IRS: 2-Year Forward Rate Minus Spot Rate

It is interesting, too, how the same levels for T-bills and swap spreads which existed about a year ago, indicated a completely different expectation: back then low bill rates came from a flight to safety and higher spreads happened because interbank markets were frozen due to counterparty fears. Same numbers, different explanation..

Monday, October 19, 2009

It's The Banks (Plus Kissinger On The Dollar And China)

If you are wondering what lead the recovery of broad stockmarket indexes, look no further than the chart below (click to enlarge). A comparison of relative performance between S&P 500 (yellow line) and the KBW bank share index (black line), it shows that banks rose almost three times faster, since the market's nadir in early March 2009.

BKX +160% vs. SPX +60%

The reason for such outstanding performance is quite simple: Washington's credo of "too big to fail", i.e. trillions in public bailout money. Once it was fully understood just how far the Fed and Treasury were willing to go to prevent "our crowd" finance from going under (sorry Bear, sorry Lehman you weren't "in"), the rebound happened almost instantly.

And it's not only happening in the United States. In the same period bank shares have broadly outperformed in Europe, too: the DJ EURO STOXX (Banks) index is up 175%, whereas the broader index is up 60%.

DJ EURO STOXX (Banks): + 175%

DJ EURO STOXX 50: +60%
Charts: STOXX

Such nearly identical behaviour between American and European markets is not a coincidence, of course. Even though the EU does not possess a common Ministry of Finance (Dept. of Treasury), it does have one European Central Bank. And it is acting just like the Fed - at least as provider of ultra-cheap credit to banks in return for dodgy collateral.

As of last week, the ECB's own balance sheet has grown 50% to 1.8 trillion euro versus 1.2 trillion in the same week in 2007. The entire increase has come from long-term refinancing operations (i.e. term lending to banks against collateral) and "other" securities held for its own account.

Important P.S.

Henry Kissinger is no dummy, whatever you may think of his politics and career. He had this to say about China, the US economy and the dollar, during an interview with Le Figaro, France's newspaper "of record". (In my dear friend Debra's honour, I have kept the title of the article in the original French. The rest of the relevant passages I translated into English, with some help from Babel.)

«Les Chinois ne veulent plus de la domination du dollar sur l'économie»

Q. You just returned from Beijing. What is the feeling of those Chinese in government about the international financial crisis, which started in the summer 2008 in the United States?

HK. I will give you my personal opinion, which is only that of an informed observer. I do not speak on behalf of the Obama administration, for which I have much respect, but to which I do not belong. There are always important political divergences between the Chinese and us, the Americans. They are not very serious, they do not threaten peace in the world, but they exist. They are managed by very intense diplomatic relations, by the existence of very many work groups between our two countries.

The Chinese do not trust America to carry out the great political affairs of the planet well. They find that ideology forms too large a part of the way in which Americans conceive international relations. On the other hand, the Chinese, before this financial crisis, regarded us as serious and reliable people in the fields of finance and the economy. They trusted our model and wished even to imitate it. The violence of the crisis, the irresponsibility shown by the great institutions of Wall Street much surprised and shocked the Chinese. We deeply disappointed them.

Today, they have accepted their losses, but they will never again trust us in financial matters. This is the great change. As they are pragmatic people, they understood it was necessary to manage this crisis in co-operation with us, so as to limit the damage to the real economies of our two countries. They take into account that a very large majority of their immense monetary reserves is in dollars and that their exports of consumer goods to America remain vital to the health of their manufacturing industries. The Chinese leaders managed this crisis in co-operation with their American counterparts during the last twelve months, and they will continue to do it. But nothing will be like before.

Q. You alluded to the fact that the director of the central bank of China declared, at the beginning of this year, that the dollar could not continue to be the world's reserve currency, and that the world should seek to create another standard, applying the model of the SDR (Special Drawing Rights ) of the IMF?

HK. It is clear that the Chinese do not want the dollar's domination of the worldwide economy any longer. They do not yet have a real solution, they know that it does not depend only on them, but they are patient people, who are accustomed to rise to long-term challenges. As always, they will only act very gradually.

Hmmm.. Bob Fisk a couple of weeks ago, now that ultimate realpolitik operator (and original China hand) Henry Kissinger. Anyone think warning rockets are being sent up? Eh?

Thursday, October 15, 2009

Ending The Happy Hour

Regular readers know that I am a "deflationist", i.e. I believe that the current Great Recession is already characterized by asset and credit deflation, which will likely deepen and widen further before the global economy rebounds.

Needless to say, this view is not shared by several academic analysts and gold-standard theorists - and most definitely not by commodity speculators who, however, are mostly talking their "book". Some even mention the possibility of hyper-inflation, a la Weimar Republic.

For everyone's consideration, then, here is another piece of the puzzle: foreign/international holders now own $3.5 trillion of Treasury debt or 50% of the total, up sharply from $1.06 trillion and 30% in 1999 (see chart below, click to enlarge).

You Wanna Do What To My Money?

The simple point is that powerful foreign creditors, e.g. China and the oil Arabs, now stand to lose a serious - record breaking serious - amount of money, should the US go down the inflation route to rid itself of onerous debt. It follows that they will not sit idly by, looking at their savings turn into so much dust in the wind (do I hear "oil embargo"?).

Judging from the increasing noise emanating from places like Beijing and the Gulf about dumping the dollar as the major global reserve currency, the Obama administration is clearly being sent overt warning messages. Happy hour at the bailout saloon should come to an end, they seem to be saying. Stop serving out the monetary booze and concentrate instead on bringing back a semblance of normalcy in interest and FX rates.

Tuesday, October 13, 2009

Six Month Sigmas

Today, I put my quant hat on (a small one, to be sure) and go trawling in stockmarket data, specifically the historical performance of S&P 500 over six months. The reason I chose six months for my yardstick is because shares bottomed out in March 2009, i.e. six months ago.
  • First, the raw performance data going back to 1871 in chart form (click to enlarge).
From -40% to +40% In Six Months
Data: Robert Schiller/Yale

One immediate observation is that the market has just swung from one near record (-40%) to another (+40%) between March and September 2009. Since 1871, only the Great Depression era exhibited greater swings in share prices.
  • How unusual is such an event, from a statistical standpoint? Let's look at the next chart, a familiar distribution histogram (click to enlarge). The median 6-month performance is +3.1% (the mean is 2.7%) and the standard deviation around it (known as sigma, denoted by the Greek letter "σ") is 12.2%.
Back in March we were in -3σ territory and at the end of September at +3σ. A three-sigma event has, by definition, only a 0.27% chance of occurrence (i.e. 99.73% of the data are inside the -3 to +3 sigma band) if the data are normally distributed (which they are not, in the case of share prices). The swing from one extreme occurrence to the next has been very, very fast.

How often does S&P 500 move from -40% to +40% within six months, i.e. how frequent are such sharply positive V-type reversals? We can identify only two previous occurrences, and they both happened between May 1932 and September 1933 (see chart below, click to enlarge).

Extreme V-Type Reversals Only Happened Before In 1932-33

How can we explain what has happened in the last six months? What is the market anticipating?

This extraordinarily rare performance indicates speculators' bets that Mr. Bernanke's massive monetarist experiment will succeed. To wit, that his enormous bailout of the financial system will prevent the credit crisis from mutating into a virulent economic crisis.

How accurate is the speculators' analysis? Well... let's just say that they're largely talking their own book. People who now call the shots in the Fed, Treasury and White House are confirmed monetarists from the Milton Friedman - Alan Greenspan school of thought, itself harking as far back as Irving Fisher, the infamous "permanent high plateau" economist who lost a fortune in the stockmarket after the 1929 Crash because he simply couldn't believe the Fed would be so conservative.

By reverse analogy, could it be that the economy will continue weakening despite the Fed's largesse? That's what I think, because today's fundamental economic problem is not a lack of adequate liquidity (and the Fed can only affect that), but a lack of enough earned income to properly service the enormous debt that households have assumed. In other words, it's a solvency problem, and it necessarily affects personal consumption expenditures, the very heart of the economy (70% of GDP).

Look at the chart below, tracking household debt as a percentage of total compensation of employees, which I use as a proxy for earned income (click to enlarge). In just the few years after 2000 it zoomed from 113% to 180%. That's a serious challenge to solvency, no matter how low the Fed keeps rates.

Sudden Debt

I am not going to attempt a conclusion, today. Instead, since I still have my quant hat on, I am left wondering what are the statistical chances of the Fed succeeding in overcoming a massive debt-to-income imbalance with just monetary tools.

I don't know the answer- and can't know - because the data sample is tiny: just one occurrence, and it's still going on.

Monday, October 12, 2009

Where The Debt Lies (..and Happy Columbus Day Mr. Krugman)

Apropos of Columbus Day and before the main topic, a comment on Mr. Krugman's editorial on monetary policy, appearing in today's NY Times ("Misguided Monetary Mentalities"). Please read it before proceeding.

When Christopher Columbus sailed west from the Old World he was merely trying to discover a faster, more profitable way to reach the well-known trade riches of India and China; he had no notion of America or the New World's vast potential. In other words, he was clueless, if also lucky.

Just like Columbus played it safe with his royal backers and their establishment groupthink, so is Mr. Krugman today calling for known and accepted palliatives for our economy's troubles: more loans, low interest rates, a weaker dollar, more government deficit spending. Not surprisingly, he points his arrows at the Wall Street Journal and selected Federal Reserve members for their sotto voce remarks on raising interest rates, soon.

Well... what if both establishmentarian views are misguided? Should we be following our outdated Neoclassical and Keynesian maps to exit the crisis, or should we strike out in a new direction? Aren't new problems calling for novel solutions? I certainly think so and will soon come back with a post on Green Finance.

Meanwhile, on with today's post.

Like the oracle of Delphi, today's post title may be interpreted in two ways: the location of debt, or the untruth of debt. In fact, this post is about both.
  • Let's start with where the debt is. The chart below (click to enlarge) breaks out marketable debt (i.e. bonds, bills, notes, commercial paper, ABS and MBS, etc., which trade on the open market). The total comes to $34 trillion and excludes loans held directly by banks and other financial institutions, plus the Treasurys in the Social Security trust fund.
Lies, Damned Lies and Debt

Until 2000 all types of marketable debt were growing more or less at the same rate; the slope of all lines is similar. One notable exception was Treasurys; because of the short-lived Clinton surplus, borrowing needs for the federal government came down. But after the year 2000, mortgage-related debt started racing ahead and finally exploded spectacularly by 50% within a mere three years. In the 2004-07 orgy of new loan origination and securitization mortgage-related securities went from $6 trillion to $9 trillion. And we all known what happened after that...

What is happening now is that Treasurys are rushing in to fill the void (a.k.a. socializing losses).
  • But wait a minute... what void? Look at the red line in the chart above: Mortgage securities are still valued at $9 trillion, after a full two years of record delinquencies, defaults and charge-offs (see chart below, click to enlarge).

Since the beginning of 2007 charge-offs for all real estate loans directly held by commercial banks come to a total of 9.5% (adding two years' quarterly rates). One would presume that mortgage lenders held on to the most attractive loans for their own books and securitized the rest, resulting in higher delinquency and charge-off rates for mortgage-related bonds. Indeed, we know that credit default swaps prices (CDS) to insure such securities against default went through the roof. Markit's various ABX indices of mortgage-related CDS collapsed anywhere from 60% to 95% (reverse scale to CDS pricing).

But even if this is not so, even if credit quality is identical between banks' own loans and those they securitized, shouldn't the value of real estate securities at the end of the second quarter 2009 be lower by about 10% to around $8 trillion, at most? And that's just face amount, never mind market value.

Therein, therefore, is where lies the lie on debt, the pretension that all's well in finance balance-sheet land. This "missing void", as it were, has been filled by no one other than the Fed itself, which last year bought $700 billion in mortgage-backed paper for its own account. Coincidence? Of course not...

Thursday, October 8, 2009

Mr. Bernanke's Class Warfare

It's been a while since I looked at the Fed's balance sheet. Here is an update.

The Fed has been supplying a massive amount of credit to the financial system in order to forestall the effects of the credit collapse. Since the end of 2007 credit extended by the Federal Reserve has jumped 136% to $2.2 trillion.

FRB Credit Up $1.27 Trillion

The Fed has done so by ballooning its own balance sheet, chiefly through the purchase of mortgage-backed securities (MBS), Treasurys and federal agency bonds, plus other direct credit and swap facilities to financial institutions. Here is a comparison of the Fed's major balance sheet assets between the end of September 2009 and a year ago (click to enlarge).

The Fed's Major Assets

Within just one year the Fed has directly purchased an additional $1.1 trillion of mortgages, Treasurys and agency securities ($700 billion mortgages, $300 billion Treasurys and $100 billion agencies). I should point out that all of these securities are held on the Fed's books at face value.

In the one year that the Fed's total assets have increased $640 billion, its own capital has increased by a mere $10 billion, to $51 billion. In other words, the Fed's Asset-to-Capital ratio has gone from 36x to 42x, even as the quality of its assets has demonstrably deteriorated. Mortgages and agencies now make up 40% of its assets, up from a mere 1.1% a year ago.

This massive expansion and radical transformation of the central bank's balance sheet is the direct result of Mr. Bernanke's theory that the Great Depression happened because the Fed did not immediately provide enough liquidity and credit to the financial system in the aftermath of the 1929 Crash. In his view, this eventually precipitated bank failures, the evaporation of depositors' savings and the transformation of a financial crisis into an economic collapse.

I am not going to argue with Mr. Bernanke's eminent academic research; his historical analysis of the 1930's is probably spot on. But I have an increasingly growing suspicion that this analysis - and thus, his current actions - are irrelevant to today's situation; that Mr. Bernanke is a general trying to fight today's war with yesterday's tactics and weapons.

My oft-repeated premise of this reasoning by false analogy, is best exemplified by the French wasting enormous resources to build the Maginot Line before WWII, a superbly constructed and equipped static fortification, only to see it immediately by-passed by Guderian's blitzkrieg panzers in 1940. Why were the French so short-sighted? Because they became mesmerized by their analysis of WWI trench warfare, when millions of their youth were massacred defending or trying to capture ill-equipped trenches. The response to their flawless analysis of the past was, however, entirely irrelevant to their future.

Likewise, there are major differences between today and the 1930's, chief among them:
  1. The U.S. was then the largest creditor nation - today it is the largest debtor.
  2. The economy was then based on manufacturing, farming and capital investment - today it is based on consumer spending.
  3. The saving rate was then around 18% - today it is 4% and a couple of years ago it even was negative. The vast majority of people today don't have significant savings to lose; instead, they owe debts that are choking them and the economy.
  4. Inequality is rampant : today 90% of all American families have median financial assets of $132,00 or less, whereas the top 10% have $405,000 (2007 constant dollars). In gross terms, then, 90% of all families are more than likely covered by FDIC's $250,000 deposit insurance (Federal Deposit Insurance Corporation).
  5. By contrast, debt has exploded upwards: families now owe an average $126,000, more than double the $58,000 twenty years ago - and that's in constant 2007 dollars. If we look at just the middle class, i.e. the middle 70% of the population excluding the bottom 20% and the top 10%, things look even worse (see table below - click to enlarge).
Debt Explosion

I'm afraid that Mr. Bernanke's actions at the Fed end up preserving debt, owed to the top 10% of the population by the other 90% of the people. His measures are not really designed to safeguard the savings of that 90%, simply because they don't exist in any serious amounts.

Maybe Mr. Bernanke can justify his actions as "saving the financial system", but a cynic could easily perceive them as Class Warfare. Because, it is one thing if a private financial institution comes to the rescue of the financial system with its own money, much as J.P. Morgan did in the Panic of 1907. But it is another thing entirely when a public institution bails out a tiny percentage of financiers and mega-rich from a disaster of their own making, and then bills the entire operation to that 90%+ of the people who had nothing to do with it.

Worse than that, worse than being ethically wrong, Mr. Bernanke's actions are also economically useless. Sure, a couple of trillion in ready liquidity has deflected the liquidity crisis, just like couple of aspirin can bring down fever. But fevers and liquidity crises are symptoms, not diseases and the economy's real problem is simply too much debt relative to peoples' income.

Look at the income distribution table below and compare it with the debt table above (click to enlarge). For example, look at the 80-90 percentile: real median family incomes have increased 19% in 20 years from $95,700/yr to $114,000/yr, but debt has increased 188% from $63,300 to $182,200. Things are even worse at the lower percentiles.

Table: FRB 2007 Survey

Income Stagnation

Bottom line: Mr. Bernanke is solving nothing by socializing and preserving debt, by substituting bad mortgage debt with federal debt, which we then all have to service and repay.

Instead of ballooning the Fed's balance sheet and engaging in de facto class warfare, Mr. Bernanke should look for ways to reduce families' debt load, most likely through partial forgiveness and default. He can't do that by himself, of course; that's a job for Congress and the President. But, at least, Mr. Bernanke should not make it easy for zombie debt to keep existing and choking American families through the public's enforced largesse. He didn't ask them, did he?

Wednesday, October 7, 2009


After yesterday's post on American national debt and the value of the dollar, a reader asked to see debt/GDP ratios for other countries as well. Here is a table from the IMF (Int'l Monetary Fund) - click to enlarge.

Government Debt As % of GDP

Japan has the largest government debt in relation to its GDP and has been in this position for over a decade, as its government has fruitlessly attempted to revive a stagnant economy by spending public money on useless infrastructure projects, mostly roads and bridges to nowhere (what if they had spent it on "green" instead?). But then again, Japan's domestic savings readily finance this debt and the yen is not a global reserve currency. This should serve as a warning for our own policy makers, who continue to serve out red ink as if it were green beer at an Irish pub on St. Patrick's day.

The US government debt is projected to reach 97.5% of GDP at the end of 2010, the third largest in the G-20 after Japan and Italy (another perennial debt basket case, with the added twist of Mr. Berlusconi as Prime Minister). In absolute numbers the US has the largest debt in the world, of course.

Now, being the world's reserve currency perforce means that an adequate supply of dollars must be available globally to act as reserves and be used in pricing and trading various commodities. But how much is, in fact, needed for these functions? That's the multi-trillion dollar question, isn't it? Too little makes the dollar too dear and strangles the global economy, while too much makes it increasingly worthless, so people don't want to hold onto it, preferring hard assets instead ( including another, "harder" currency).

For quite some time now we have been flooding the world with too many dollars, first from the private sector in the form of mortgage, consumer and corporate debt and now as government bonds. To be sure, some of those Treasury bonds and bills are simply replacing private debt that defaulted on the books of banks and investors world-wide. That's what constitutes a financial sector bailout by the government: socializing private losses.

The battle of the dollar to keep its global reserve status may, therefore, be summarized thus: can US authorities regulate the amount of newly-issued debt so that it does not exceed by much what is currently defaulting? If the Great Recession keeps the flood of defaults going, then overall debt goes down through write-offs, the absolute number of dollars declines and the dollar becomes relatively more valuable. If, on the other hand, the economy stabilizes and starts to improve there are fewer defaults, more debt on the books and the value of the dollar declines.

This explains the inverse relationship between the value of the dollar in foreign exchange markets and prospects for the economy, as seen in stockmarkets and other risky investments such as junk bonds and second-rate mortgages. Stocks go up, the dollar goes down and vice versa.

It is a bit ironic and counter-intuitive: If the US economy starts tanking again, faster than the government can issue debt and induce domestic and foreign investors to buy it, then the dollar may strengthen - for a while anyway, until the nation's ability to service this debt ultimately comes into question.

Tuesday, October 6, 2009

Sic Transit Gloria Dollarii Mundi

I have not published a chart of US public debt in some time, having mostly concentrated on household and corporate debt with its various alphabet-soup permutations ( CDOs, CLOs, CDSs, etc.).

However, after almost two years of financial sector bailouts (handing out borrowed public money to mega-rich junkies addicted to sophisticated gambling) the amounts wasted are hitting the books in a rush. They give full meaning to the title of this blog (see chart below, click to enlarge).

Sudden Debt

Public debt has increased by $2.5 trillion since just the end of 2007, when the current Great Recession is deemed to have started. It now stands at $11.7 trillion and represents 83% of GDP, up from 62% at the end of 2007.

It stands to reason, therefore, that the entire world is closely re-examining the status of the dollar as its global reserve currency. Those that are most directly affected by such a flood of new dollars (remember, more debt = more dollars) are commodity producers who price their goods in our curency, chief amongst them the oil producers.

According to Reuters, Gulf Arabs are meeting in secret (please see P.S. below) with representatives from Russia, China, Japan and France in order to agree on a basket of currencies that will be used for the daily pricing of crude oil. This is very different - and much more important - than merely settling oil trades in euro or other currencies, which is already taking place (e.g. Iran).

Unless the United States takes immediate and convincing steps to prove its commitment to a strong, valuable dollar it will very soon face the catastrophic end of Dollar Hegemony, the foundation upon which it erected its economy post-WWII. It will lose the ability to finance its massive deficits on a global scale via its own printing presses and will be forced to accept a much lower living standard.

What should be done?

It is of paramount importance to realize that the Dollar Hegemony must end, anyway. Not because other global powers desire it, but because it is in our best interests. We ourselves should base our economy upon a more robust foundation, one that is in tune with today's challenges and opportunities: environmental and climatic change, resource depletion, transformation of energy sources and networks, transportation overhaul.

We must realize that energy security is no longer achieved by waging war in Central Asia and patrolling the sea-lanes with staggeringly costly carrier forces, but by developing renewable and inexhaustible local sources. Solar, wind, geothermal, biofuels - all must come into play as quickly as possible and transform the economy into one that grows based on infrastructure capital investment, financed with domestic saving.

Expensive? I say it is cheap, considering the alternatives.

And, anyhow, we should keep honest accounting books if we wish to compare prices honestly. Once all of the external costs of Dollar Hegemony are included and properly apportioned (defence, healthcare, environmental degradation, finance) I doubt anyone in his right mind would want to keep it going - apart from those benefiting directly from it, of course. But even they have children , don't they?

P.S. The Reuters story mentioned above has already -within hours- changed title to "Oil states say no talks on replacing dollar". It is originally based on reporting by Robert Fisk, the legendary Middle East correspondent whose book "The Great War for Civilisation: The Conquest of the Middle East" I highly recommend.

I am sure Bob Fisk would never stake his reputation on a story of such obvious importance unless he was absolutely certain of its validity.

Friday, October 2, 2009


A reader commented recently that solar energy requirements and/or subsidies for homes in the USA is a no-go because not enough sunshine falls on the country. I looked into it and the following map should enlighten us (pun intended, click to enlarge).

Average Daily Solar Radiation

The data are for a flat panel that rotates automatically along two axes in order to track the sun and capture as much energy as possible.

So... even in Fargo, North Dakota (lat. 46'52"N, no palm trees in sight) such a system would get on average 6-7 kWh of solar radiation per day, for every square meter of panel. Even with the least efficient panel available currently, at around 10% energy conversion, this means that for a mere 10 square meter system a home would generate ~6.5 kWh per day. And I should point out that panels are now being tested with conversion efficiencies upwards of 20%.

The rub? Price, as always. And that's where your government feathers (see previous post) come in. How about this idea: we reduce defence spending by $30 billion/year and increase "black" fuel taxes by $30 billion/year and spend the $60 billion in installing state of the art solar panels in people's homes FOR FREE through a lottery system. That should come to about 2 million installations every year. Not bad for such a small bunch of feathers, eh?

For your information, the federal government already spends $600 billion on defence every year. As for the other $30 billion, we could raise this entire sum by an extra 10 cents tax at the gas pump.