Please, click here to read this article in pdf format: november-1-2010

Action this week will be completely driven by political events. In Brazil, Lula’s successor, Dilma Rousseff has won this weekend’s ballotage. In the USA, the markets have priced a Republican victory, which in our view, will not affect the present course of monetary policy but may, if the victory is serious, impact fiscal policy. The Tea Party has not succeeded “infiltrating” the Republican party. Therefore, the USA may find that their next congressmen support lower taxes at unchanged spending (i.e. not higher, but not lower either) levels, without even really analyzing the role of monetary policy. In other words, fiscal deficits will not decrease, regardless of who wins this week and the Fed’ role will remain unchallenged.

On the other hand, we also have policy meetings of the European Central Bank and the Bank of England. In Europe, we have recently witnessed renewed concerns over the long term solvency of peripherals. In particular, demagogic rhetoric has taken place in Greece again, and its sovereign risk has widened, vs. Germany’s. But this time, Europe gets it. It gets that the weakness of the Euro is of an institutional nature and seems decided to address it so. On October 28th, EU leaders agreed to amend the Union’s Treaty, seeking to establish a debt-crisis mechanism. It appears that the initial intention was (or may still be) to suspend the voting rights of those members that violate the EU’s deficit and debt rules. This will lead nowhere. The only way to see the survival of the Euro is with the creation of an unified Euro sovereign debt market. This can only be achieved with total integration, under a federal structure. And this, we think, shall not happen any time soon.

Together with the institutional discussion, on October 28th too, an article published by The Telegraph was circulating and making waves: It suggested that under a draft proposal from Berlin, an “orderly insolvency” mechanism was being sought, under which bondholders would share losses in future bail-outs (http://www.telegraph.co.uk/finance/economics/8094324/EU-haircut-plans-rattle-bondholders.html ).  It is not clear to us how someone could come up with such idiocy at this moment, when peripherals most need to prove they have access to the markets, given the absence of an explicit guarantee by core Europe. In this case, like in any other, bondholders will demand either a guarantee or more collateral. Anything that hints a solution farther away from an improved guarantee or collateral will only make it more expensive for peripherals to raise money pushing them to depend even more on Germany or the European Central Bank.

Lastly, we have come across exhaustive research on the prospective impact of the Fed’s upcoming Quantitative Easing 2, in which ever form it may finally appear. There are numerous studies circulating which speculate on the what the impact will be, if Treasuries purchases start at the $100BN level per month or more. Everyone is trying to come up with the next trade idea in swaps, the curve, relative value, credit spreads, currencies and gold. We will not and cannot add anything here except to note the following: Nobody seems yet to be aware of the “dynamic” nature of the problem. As we wrote before, macroeconomic theory should not be about real income determination, but about coordination. We are not concerned with determining how many bps the 10-yr Treasury yield will tighten if $100BN rather than $500BN are purchased by the Fed. What concerns us is that the market will progressively adapt to the new “rate of money supply”.

The developed world is still not used to the idea of “passive money”. Passive money is a relatively foreign concept to most contemporary economists, but its research began as a consequence of the problems Latin America faced in the ‘60s and ‘70s, when monetary policy turned accommodative, responsive to the unemployment rate. The concept of passive money was, in our view, the foundation to what was later called the “structural” explanation of inflation or the notion of “structural inflation”.

For those interested in learning about the concept of passive money, please refer to: “On Passive Money” , by Julio H. Olivera, published in July-August of 1970, in The Journal of Political Economy: http://www.hilbertcorporation.com.ar/olivera1970.pdf

We think the review of this concept is worth understanding, because we have no reason to doubt the Fed is taking the path of passive money (i.e. labour standard) and other central banks will have to soon follow. Gold, therefore, is bound to go higher…

Martin Sibileau