Please, click here to read this article in pdf format: september-14-2010
Since our last letter, nothing relevant has taken place. The world keeps bidding for risk since the announcement that banks are not going to be required to raise capital as fast as expected. The European Monetary Union, with its fragile banking system is  the big winner here. But as we said, this is not relevant, because this is more of the same.

If we had to summarize the macro picture today, we could say that while the US is trying to implement a Keynesian solution to the financial crisis and falls short of the recipe (i.e. money supply does not fall, but does not increase either), the European Union refuses to accept problems and hides the dirt under that big rug called the European Central Bank (i.e. the stress tests were a bad taste joke). On the other hand, the UK shows inconsistency in reducing spending and increasing taxes, while Japan seems lost in terms of how to address capital inflows. That leaves the Swiss Franc and commodity currencies as the best looking alternatives, but for the latter, this only applies as long as activity levels don’t disappoint (i.e. Chinese tax payers keep footing the bill with their purchasing power depressed).

Speaking of activity levels, we are constantly hearing / reading about a concept which we think is flawed, namely how negative is for an economic system to have current output below “potential” output. This is a very “mainstream” concept. The Taylor rule, for instance, is based on it (refer: http://en.wikipedia.org/wiki/Taylor_rule )

This whole concept, in our opinion, is an absurd. There is no such a thing as “potential” output. The mere idea of its existence implies that the role of the pricing system in the resource allocation process is irrelevant. Why would firms not produce to capacity, unless doing so is unprofitable? When firms do not produce up to their potential, they make a conscious, educated decision not to do so. The fact that they have the capacity to produce more is irrelevant, because doing so would generate a cost which is not compensated by the marginal revenue, including the risk of holding unwanted inventory. Furthermore, how can we measure what the potential output for an economic system is, when a whole different set of relative prices would be required to achieve that additional employment of resources? Who can claim knowledge of that set of relative prices that will take a system to full capacity? The assertion that such a set of prices is known goes against the assumed neutrality of money that central banks employ in their models (i.e. Taylor rule).

The source of the problem is the original miscalculation of firms, when they purchased the capital goods that allowed them to achieve that higher capacity. They did so because the respective cost of capital was lower than what the risk apparently entailed.

If up to here you thought these comments were of academic interest only, we beg you to look closer at what has just happened yesterday, post-announcement of the implementation of higher capital ratios. The mandate for what was considered a prudent 7% capital ratio has been delayed until 2019 and investors, after receiving this “price” signal, decided to dump good money after bad to a financial system that is now becoming incapable of distinguishing a real from a nominal return (if you refer to our previous letters, you will see that we have never been believers in either stress tests for the Euro zone or higher capital ratios to decrease systemic risk, as long as central banks remain alive)

This specific announcement lowered the cost of capital for banks, with the intention of increasing the banks’ “output”, i.e. making more loans. Relative prices for risk (i.e. what the bank buys) have not changed. There has been no intrinsic, fundamental change, for instance, that should justify a 1.1% daily increase in value of the S&P500 we saw yesterday. However, given the lower cost of capital, risk shall be in higher demand. Credit spreads shall further compress and the distinction between good and bad credit risk will be blurry at best and absent at worst.  In the event that it may take too long to increase that demand, banks will also seek to merge, and the so feared too big to fail institutions of 2008 will look like babies by the time the next crisis arrives. Have we learned anything in the last three years?

The global economy is not underachieving. There is no potential output we need to get back to. What we need is to return to a transparent and efficient pricing system, so that we can all (this is already an issue of global proportions) save and consume what we want, not what politicians want us to, and resources can be allocated to those enterprises that have an effective demand.

Martin Sibileau