To read the June 9, 2013 letter, please click here.

As we are in the final stage of the global bubble, I realize that we often fail to ask the most obvious questions. In this case, as every central banker tells us that his policies are directed to obtain growth, the obvious question is…how do we define economic growth? What is economic growth? Yes, yes, I know that what they do is simply monetize deficits and enable the transfer of wealth between sectors and generations, but there is also an intellectual battlefield, which we should be aware of.

In the next sections, I will (extremely) briefly walk through the history of the idea of economic growth to this day. Obviously, I cannot be exhaustive and I encourage you to do further research on the works mentioned below. At the end, I examine what view policy makers have on economic growth, if any…

When did the idea of economic growth first appear? Up to the 18^th century, economic thinking was predominantly concerned with comparative statics, intellectual exercises designed to establish causes and consequences of policy making.

I dare to suggest that the concern on economic growth grew before the French Revolution, when the distribution of income was first examined. My suggestion contradicts Nicholas Kaldor, who finds David Ricardo pioneering the theory of distribution. Although David Ricardo explicitly says in the preface to his “Principles of Political Economy and Taxation” that: “…To determine the laws which regulate this distribution, is the principal problem in Political Economy…”, my view is that this perspective had already been adopted by Francois Quesnay, in 1759, and was the foundation of the Physiocracy. If agriculture was the basis of economic growth, a distribution of income favouring this sector was thought to be advisable. I copied below the very same Tableau Economique, probably the first economic model (designed by Quesnay):

The idea that there was an “optimal” distribution of income triggered the investigation of what determines the same. Simultaneously and brewed by Malthus, there was another idea: Full employment requires a growing income. Perhaps this idea, which we are reminded of every two months by the minutes of the Federal Open Market Committee meeting at 2:15pm, goes all the way back to Karl Marx.

It was on these two pillars (i.e. distribution of income and the relation between employment and output) that the modern theory of economic growth was born, with the additional analysis of how capital is created.

The first “modern” discussion on economic growth is probably that of R. F. Harrod, titled “An Essay in Dynamic Theory”, published in 1939.

Harrod’ work has historical relevance although it is not original and merely seeks to give Keynes’ thought a dynamic dimension. His main assumptions are that the supply of savings is determined by income (i.e. interest rates play no role, which would have probably made him a good FOMC member). For Harrod, investment responds to income growth and there is always equilibrium in the savings market.

Just like in the rest of the modern discussions on economic growth, monetary aspects are completely ignored. There is a constant concern –sometimes turned into an obsession- to address equilibrium conditions.  These analytic frameworks are Walrasian in structure (I also discussed Walras here) and ignore the impact of aggregate leverage in a credit-based monetary system. I think there is no excuse for such omission, for it is clear that already in the 1930s the Austrian school was very much aware of such impact.

Harrod worked within a single commodity and production factor model, and held that a departure from equilibrium would activate a self-fulfilling, spiraling instability.

He anticipates Ben Bernanke and followers, when he asserts that to address such instability, policy is required: “…The ideal policy would be to manipulate the proper warranted rate, so that it should be equal to the natural rate…” Sounds familiar?

After World War II, Evsey Domar presented his work “Capital expansion, rate of growth and employment”, in January 1946.

Domar incorporated prices into his model, but assumed no fluctuations. Unlike Harrod, he was not obsessed with equilibrium in the savings market, but discussed the generation of capital in an economic system. He brought attention to the issue of full employment: “…Our first task is to discover…the rate of growth at which the economy must expand in order to remain in a continuous state of full employment…”

He was not just referring to the employment of labour, but of capital too.  In this regard, he precedes John B. Taylor’s famous “rule”, because he examines the dynamics of the gap between potential and actual output (he actually focused on the relation between change in output and investment, which he called potential social average investment productivity).

Almost a decade later, economists were still working with the assumptions that the factors of production were fixed and that the monetary context had no impact on economic growth. James Tobin was to challenge the status quo in a paper titled “A Dynamic Aggregative Model” published in April of 1955, by the Journal of Political Economy.

For Tobin, economies have constant returns to scale (“…if labor and capital expand over time in proportion, then output will expand in the same proportion…”). His innovation is the introduction of “asset preferences”, as one more variable affecting economic growth.

Tobin assumes that we either hold currency (zero interest) or real assets. There are no financial assets (i.e. paper that pays a rent). Inflation or deflation is therefore the product of shifts in our aggregate allocation, between currency and real assets, driven by preferences. For instance, if we decide to hold less currency (i.e. we bid for real assets), there will be inflationary pressures.

Interestingly, he realized that technological progress is deflationary, and recommended monetary expansion to offset deflation. His merit was in understanding the implication of said expansion. Tobin tells us that the same “…cannot be accomplished by monetary policy in the conventional sense but must be the result of deficit financing… (…)…clearly, such a discussion requires the introduction of additional types of assets, including bank deposits and private debts…” In other words, he anticipated our current “problem”: Lack of collateral, in a credit-based system with shadow banking. For a good discussion of this system, read here, from Zerohedge.com. Tobin concludes that under such expansion”…the normal result is that consumption will be a larger and investment a smaller share of a given level of real income…”

Mr. Solow is “the” name in the theory of economic growth. His work on this field eventually earned him the Nobel Prize in Economics, in 1987. His ground-breaking work appeared one year later than Tobin’s, in February 1956, published at the Quarterly Journal of Economics and titled “A contribution to the Theory of Economic Growth”.

Solow takes Harrod’s and Domar’s research but abandons the assumption that production takes place under conditions of fixed proportions (between labour and capital), allows for a rate of technological change, and incorporates an interest rate-sensitive savings function.

Solow’s conclusions are powerful and based on the axiom that in the long-run, our economic system has constant returns to scale. The main conclusion is that full employment (or perhaps I should say, an optimal ratio between labor and capital) is not (as suggested by his predecessors and Ben Bernanke) obtained from a key level of output/income, but from a key marginal productivity of capital, which in turn determines the real wage rate. How do we get to that key marginal productivity of capital? Thanks to perfect price flexibility, within a stable monetary system (implied; for those interested, refer equations 10-12 of his model). Lastly, Solow incorporates technological progress as an exogenous (i.e. arbitrary, not determined by his model) and neutral variable.

It’s a pity –in my opinion- that Solow did not explore the monetary aspects implied in his work. His idea of economic growth makes sense under commodity-based money (i.e. no central banking), because one can reasonably agree with him on the elasticity of supply of factors (capital and labour, he excludes land) to their respective prices (interest rate and wages). But I guess that if he had done that, he would have been an Austrian by now, and possibly less popular… Robert Solow is currently Institute Professor of Economics emeritus at MIT and recently wrote (here) on the ongoing financial crisis.

The Austrian School

I do not think that one can point to a unique author within the Austrian school, on the theory of economic growth. In fact, the Austrian school rightly denies a special spot to economic growth and focuses instead on what Jesús Huerta de Soto calls “dynamic efficiency”. If humans act purposefully and the price system works freely, all it takes to improve our standard of living is to allow markets to allocate resources where consumers want them to be. The market is a cooperation and coordination process.

With regards to income distribution, Von Mises made the case that it is a flawed concept. We do not produce something and then distribute the income generated by it. The distribution of that income is already decided, agreed and precedes production. And that product gets made precisely because of and not in spite of, that agreed income distribution.

With regards to the full employment of resources, under a transparent market, with prices signalling where resources are needed and were they are not, unemployment is simply at a natural and low rate, the result of constant change/creative destruction.

Equilibrium is a ridiculous concept, because under it, no change would occur. It is exactly that constant reallocation of resources, carried out by the entrepreneur (an absent figure under all other economic schools) the factor that increases our efficiency, our productivity. Hence there is no need for an optimal savings rate or an optimal stock of capital.

Money and financial assets are relevant, because as medium of indirect exchange and store of value, respectively, they enable the necessary coordination among humans to satisfy their needs. This coordination leads to specialization and improvement of production methods. When money dies under inflation, specialization dies with it too. Risk-taking is acknowledged and not exogenous. It is the blood of entrepreneurship.

If I still have to name economists within the school that focused on the idea of growth, I come up with three: Roger Garrison (Auburn University and adjunct scholar of the Mises Institute), Israel M. Kirzner and Frederick Von Hayek.

Having very succinctly mentioned the topics, axioms and conclusions around economic growth, we can legitimately ask ourselves what position policy makers of the 21^st century have on the same.

Let’s start by acknowledging who the policy makers are: The global cartel of central banking. Fiscal policy is non-existent or even subdued, repressed, as members of the European Monetary Union are witnessing. All members of this cartel are highly educated and many of them even have an academic background, I would expect from them to have a view on each of the topics mentioned above. Let’s see…

Income Distribution

Apart from the explicit wealth transfer from taxpayers to the banking and government sectors, and the implicit ones (a) from wage earners to stock holders and (b) from future generations to the present one, I am afraid that there is no clear, laid-out view with respect to an optimal distribution between labour and capital. Not that I endorse one, as I agree with the Austrian perspective, but I would assume central bankers have an opinion on this point.

Proportion of production factors

The current zero-interest rate policy has completely inverted the risk-return relationship in the capital structure of the centrally planned economies. For instance, banks act like private equity firms. It is now the new normal to see a bank extend a loan at below market prices to win a debt or equity mandate. Once that loan has given the financial support to proceed with public capital raising, it is also normal to see the same companies implementing share buybacks or dividend payment increases, either with bank debt or public capital. There is also no concern about the distortions generated in the labour market by the ultra-low interest rates or the labour legislation itself.

Output growth

Growth in output is the target of economic policy in any mainstream discussion. The approaches differ not in how to get there (all opinions agree in that the stock of capital has to grow) but in how the stock of capital can best increase.

What is the view of the central banking cartel on how to grow output? Surprisingly, not via an increase in the marginal productivity of capital, but via the so called wealth effect: As interest rates fall, asset prices increase (it doesn’t matter which assets see their prices rise) and the assets can be used as collateral to leverage a higher than previously possible consumption level. This consumption level will drive output growth, and this increase in output –they believe- will bring about full employment.

The wealth effect is mistakenly attributed to Keynes, who actually argued against it:

“…For whilst an increase in the quantity of money may be expected, cet. par., to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money; and whilst a decline in the rate of interest may be expected, cet. par., to increase the volume of investment, this will not happen if the schedule of the marginal efficiency of capital is falling more rapidly than the rate of interest; and whilst an increase in the volume of investment may be expected, cet. par., to increase employment, this may not happen if the propensity to consume is falling off.…”Chapter 13, , The General Theory of Employment, Interest and Money

Thus, the central banking cartel has its own interpretation of economic growth and it does not fit any of the perspectives presented above.

This was a very, very brief discussion on economic growth. I understand it may have been too abstract and I tried to make it as easy to understand as possible, because I firmly believe that there is value in a historical perspective on economic thought, vis-à-vis current policy.

I discussed only those works I was more familiar with and omitted other important economists, in no particular order, like Hicks, Swan, Robinson, Phelps, Malinvaud, Arrow, Kahn, Kaldor and Sidrauski .

M. Sibileau

A week later and everyone is a bit more nervous, with the speculation that US sovereign debt purchases by the Federal Reserve will wind down and with the Bank of Japan completely cornered.

In anticipation to the debate on the Fed’s bond purchase tapering, on April 28th (see here) I wrote why the Federal Reserve cannot exit Quantitative Easing: Any tightening must be preceded by a change in policy that addresses fiscal deficits. It has absolutely nothing to do with unemployment or activity levels. Furthermore, it will require international coordination. This is also not possible. The Bank of Japan is helplessly facing the collapse of the country’s sovereign debt, the European Monetary Union is anything but what its name indicates, with one of its members under capital controls, and China is improvising as its credit bubble bursts.

In light of this, we are now beginning to see research that incorporates the problem of future higher inflation to the valuation of different asset classes. One example of this, in the corporate credit space was Morgan Stanley’s “Credit Continuum: Debt Cost and the Real Deal” published on May 17^th, 2013. Upon reading it, I was uncomfortable with the notion that inflation is the simple reflection of the change in a price index, which implies the thesis of the neutrality of money. For instance, the said research note discusses how standard financial metrics compare vis-à-vis a rate of inflation.

Why is this relevant? The gap between current valuations in the capital markets (both debt and credit) and the weak activity data releases could mistakenly be interpreted as a reflection of the collective expectation of an imminent recovery. The question therefore is: Can inflation bring a recovery? Can inflation positively affect valuations?

I am not going to comment on others’ views or recommendations, but on the underlying method. A price index is a mental tool that has no relation to reality. In the real world, we trade driven by relative prices. To infer economic behaviour off changes in a price index is a mistake. The impact of inflation is more complex. For this reason and in anticipation of future debates on this topic, I offer you today a microeconomic analysis of such impact, on value.

Framework

I suggest that a good way (but certainly not the only one) to assess the impact of inflation on the valuation of a firm is to think of the same within the typical free-cash flow approach. After all, what matters is not how inflation can affect a certain component of its capital structure, but how the entire value of a firm is impacted, before the same can be shared among the different contributors to the said capital structure (i.e. equity, debt holders, etc.)

Simplifying, as far as I can recall from the times when I worked in the area of Private Equity,  the way to calculate the free cash flow of a firm for a determined period is to obtain its operating margin, add to it depreciation & amortization costs and subtract capital expenditures, changes in net working capital and taxes. I show the formula below:

Revenues

– Operating Costs

Operating margin

+ Depreciation & Amortization

- Capital Expenditures

- Change in net working capital

- Operating tax

Free Cash flow

What follows is a discussion on the impact of inflation on each of the components of the valuation formula above:

Revenues (= unit price x volume sold)

Under inflation, only those firms that have pricing power can defend the value of their production. At the same time and because inflation brings unemployment and the destruction of purchasing power, in general (not for all firms, of course), sales volume drops too. This backdrop encourages consolidation, where big players get bigger and small ones disappear. With it, the bigger firms obtain oligopolistic to monopolistic pricing power which assures two things: The currency zone where this development takes place loses in innovation and prices become less flexible. This inflexibility, when fully unfolded, directly leads to indexation, which is the stepping stone for any hyperinflationary process. If the consolidating firms are public, it is likely that during the consolidation process they become private via leveraged deals, as long as credit is still available.

Operating costs (=unit cost x volume bought + factors)

With regards to direct inputs, the same pricing problem described above arises. There are those firms that have leverage with their suppliers and can force these to delay price increases (i.e. margin contraction) and those that can’t. Consolidation therefore pays off on this front too, carrying the same consequences mentioned above. From an accounting perspective, when inflation is high, firms can’t even measure the cost of their inputs and are forced to take a Schrodinger approach, with either Last in-First Out (LIFO) or First in – First Out (FIFO) accounting.

With regards to indirect inputs, these can be segmented into labour and capital. Labour intensive firms will struggle with a unionizing work force and inflation always nourishes the growth of unions, to renegotiate labour contracts. All things equal, this context simultaneously encourages higher unemployment and illegal immigration, because while credit is available at negative real rates (i.e. the nominal interest rate is lower than the inflation rate), firms will find more convenient to replace labour with capital. This takes place during the lower stages of an inflationary process. In later stages, credit disappears and the higher interest rates make refinancing debts unfeasible, bankrupting those firms that dared to invest in capital expenditures.

Where the required labour is low skilled but expensive due to social security legislation, firms will also replace it with illegal immigration, whenever possible.

Conclusion

The impact of inflation on operating margins (i.e. revenues – operating costs) is to drive consolidation, the replacement of labour by capital, indexation, price rigidity and the loss of competitiveness. The loss of competitiveness is the natural result of an environment that favours oligopolistic/monopolistic structures and short-term investment opportunities. It is very common to blame entrepreneurs or management for this outcome. However, the conditions that drive firms to adopt these survival strategies are the exclusive responsibility of politicians.

Depreciation & Amortization

“…Both depreciation and amortization (as well as depletion) are methods used to prorate the cost of a specific type of asset to the asset’s life…these methods are calculated by subtracting the asset’s salvage value from its original cost…” (Investopedia)

It is clear that any attempt to accurately portray the value and life cycle of fixed or intangible assets under inflation becomes irrelevant. What if due to high inflation the salvage value of an asset is higher than its original cost?

Under inflation there is uncertainty on the true cost of maintaining the fixed resources involved in the operation of a business. This uncertainty forces firms to cut back on capital expenditures. Investment demand and economic growth therefore collapse

Capital expenditures

Because nothing can be reasonably forecasted under inflation and growth and efficiencies are better served via consolidation and without innovation, capital expenditures can only be of a very short nature, if any.

Change in net working capital

This item is perhaps the most neglected and yet, most relevant, in my view. For valuation purposes, an increase in net working capital means that a higher amount of capital is tied to the operations of a firm. Therefore, a lower amount of cash is available to the contributors of capital to the firm (i.e. debt and equity holders). For this reason, the change in net working capital is subtracted in the valuation formula above.

What is net working capital? In simple terms:

Accounts receivable

+ Inventory

-  Accounts payable

Net working capital

If from one period to another the time necessary to collect on accounts receivable increase and/or the inventory turnover necessary to run an operation decreases, the value of the firm falls, as less cash is available to the contributors of capital. Alternatively, if the firm manages to increase the time necessary to honor accounts payable –all things equal- more cash is available.

What is the impact of inflation on net working capital? Complete! Under inflation, firms seek to delay any cash outflow. The higher their accounts payable, the more debt they dilute. At the same time, bank lending quickly shrinks. At high inflation levels, even working capital lending disappears. At this stage, vendor financing is key and only those companies that demonstrate a steady commitment to their suppliers can obtain credit from them. Suppliers, on the other side, often go bankrupt precisely because they cannot collect on their receivables. One of the painful ironies of inflation is that under it, liquidity evaporates!

With regards to inventory, this is counter intuitive, but firms will try to maximize its amount, as long as they can get vendor financing. The accumulation of inventory allows firms to lock in a cost of production that would otherwise be uncertain. This is very inefficient. Just-in-time production models become totally unfeasible. The accumulation of 

inventory is more understandable when one realizes that inflation is the destruction of the medium of indirect exchange, which forces us to barter. Under barter, inventory is not a burden.

Just as much as firms seek to delay cash outflows, they will want to collect as quickly as possible. Those firms that operate at the end of the distribution chain and can sell to a granular, cash-paying public will be at an advantage over those that operate at earlier links of the chain (and have a concentrated customer base which demands vendor financing). Inflation therefore leads to consolidation on this basis too, towards the end of a distribution chain.

An example of a firm that would fit this profile, benefitting from an inflationary context would be Costco Wholesale Corp. (and no, this is not an investment recommendation, but a hypothetical example). As Costco sells in bulk, its customer base would grow, since the public that seeks to escape from a devaluing currency and lock the price of necessary staples would see an advantage in purchasing the same in quantities, at a discount. Simultaneously, the company would be in a privileged position to exert pricing power over its suppliers and grow via acquisitions. As an extreme (but illustrative) example, I recall that during the ‘80s in Argentina, when employees were paid their salaries, many took the day off (and parents left their kids with nannies) to go shopping. They were simply ensuring that not one day would pass with them holding depreciating currency, which had to be exchanged as fast as possible for all the goods that were going to be consumed until the next wage payment. They set off in a hurry and bought, when possible, in bulk!

Operating tax

Tax payments are simply one more cash outflow. Even without inflation, one tries to minimize and delay this outflow. Under high inflation, delaying its payment is a matter of survival and represents and additional source of

financing. Because all hyperinflations took place before the internet era, we don’t know how easy it will be to delay tax payments when the next hyperinflation arrives. I imagine it will be much harder in the digital era.

The inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth. The microeconomic impact described above brings the following unintended and unnecessary macroeconomic consequences:

-Oligopolistic/ Monopolistic structures

-Loss of innovation, competitiveness

-Indexation, price rigidities

-Unionization of labour force and higher unemployment

-Illegal migratory flows

-Destruction of public capital markets

-Higher fiscal deficits

If this analysis is correct, the record asset values we see today cannot be interpreted as the omen of an imminent recovery. I am not saying that these nominal values are not justified. What I am saying is that they should not be interpreted as an indication that economic growth is on the way □

Martin Sibileau

I am back from a brief trip to Argentina’s Patagonia, where I could confirm first-hand the irreversible damage caused by interventionist policies: Widespread poverty, abandoned infrastructure, scarcity of consumer goods, unseen unemployment and criminality, etc. I could also see for myself the madness of hedging against inflation with the purchase of new cars. The streets of any forgotten small town in Patagonia are filled with brand new 4×4 vehicles that would be the envy of many in North America.

While visiting too, the Argentine government made a new move to suppress the price of the physical US dollar. In previous articles (here and here), I made the case that the broken US dollar market in Argentina would provide insights into what we may eventually expect from the gold market, if it broke in the same fashion. However, I had underestimated the magnitude of the USD physical market. Zerohedge brought attention to this point a few days ago (here).

Overview

In August of 2011, Argentina’s government slowly began to implement a series of actions destined to curtail the right of citizens to access US dollars (foreign exchange in general). The goal was and is to force savings into pesos, as pesos are after the taxable asset in a country that cannot access capital markets and fully monetizes its deficits.

From that moment onward  physical US dollars started to trade at a premium. Last week, with the paper US dollar value at 5.11 pesos, that premium was over 100%. Physical US dollars, i.e. dollars outside the system, reached a bid/ask of 10.30/10.45 pesos. The chart below should help visualize this dynamic (source: Reuters/La Nación)

The latest move: Tax moratorium to repatriate capital

With a 100% premium over the “official” price of the US dollar, on May 7th, the federal government announced a moratorium for off-shore capital (see here, in Spanish). A simple reading of this measure would reveal a government encouraging capital inflows to an investments-starving nation. The moratorium, after all, is for capital directed to the real estate and energy sectors. The real intention behind it is, however, to narrow the gap between the official and black market price of the US dollar, via manipulation of the “official” price, as I will show further below. At the official price, of course, one finds no sellers.

The moratorium is a tax pardon, no questions asked, for all Argentines who decide to bring onshore their undeclared US dollars deposited offshore. Although it is not clear yet whether the declared funds can be freely disposed of, the government seeks that they be applied to the purchase 2016 4% bonds issued by the federal government or USD certificates, issued by the central bank. These USD denominated certificates (see image below, source: La Nacion) are to be used to clear transactions in the real estate sector, are fully endorsable and have no maturity. In other words, the government wants to further segment the US dollar market.

I can’t help speculating that years into the future, one would see a developed country implementing a similar measure to repatriate undeclared gold.

How it works

The tax moratorium is a simple transaction. Let’s forget about the USD certificates issued by the central bank that pay no interest and assume that the public will accept them like US dollars. We are talking about a public that already holds 1 every 15 US dollar bills in the world. My view is that these will not prosper, because I doubt that anyone selling real estate would be willing to take them at face value.

We are left with the 4% coupon bonds issued by the federal government, maturing in 2016, which are bought by offshore depositors. The figure below shows the accounting:

Final Observations

By now it should be clear that if the Argentine government had only wanted to attract offshore capital to fund investments, there would have been no need to have the Government Issue interest paying certificates.

It is also obvious that for this policy to be successful, offshore depositors must believe that declared, taxable, interest paying USD certificates are better than holding US dollars off-shore. But if these certificates are to be liquid, the discount in the secondary market should be lower than 12% approximately, in the absence of counterparty risk (4% x 3 years). And with the Federal Government of Argentina as the issuer, there is no doubt that counterparty risk is real and present. Preliminarily the government expects $4 billion to be declared.

One would find this measure laughable, as it is absolutely evident that one is better off holding undeclared funds offshore than facing scrutiny to earn a 4% interest on a certificate issued by the government of a country that defaulted on its debt and has no access to the capital markets.  Yet, in this new normal world we live in, with the announcement, the price of the US dollar fell to 8.87 pesos, which represents a considerable 13.9% drop. To put the reaction in perspective, the Argentine government jawboned the foreign exchange market more efficiently than Draghi did with the gold market upon the insinuation that Cyprus would sell its gold.

It is also a known fact that financial repression in Argentina is a publicly disclosed policy, and some may attribute the drop to the same. But I cannot deny that the reaction surprised me. If the measure is successful, would the success indicate that monies currently offshore are perceived to be in far greater danger than in a country where they can be laundered into the energy sector? To finance a company that was confiscated in 2012 to the Spanish crown?

Regardless of the initial drop (the closing price on Friday May 17^th was 8.95 pesos, while the official price was 5.25 pesos), one wonders if the Argentine government can sustainably manipulate the price of the US dollar, assuming the certificates are accepted in the market, and if there are lessons to be learned here.

Without changing the terms of the tax moratorium, Argentina’s government could replicate the tactics of the gold cartel to suppress the price of the US dollar. The way to achieve this is by expanding the credit multiplier, as shown below:

The figure above shows that with the US Dollars repatriated and in the balance sheet of the Federal Government (assets), it could be possible, assuming that the certificates are accepted, to generate a credit pyramid in the system. If the certificates are accepted in deposit by banks (step 2 above), these can use them to expand their USD loan base (just like bullion banks use the gold ETFs to expand their gold loans).

This scheme would suppress the price of the US dollar (just like gold loans suppress the price of gold), in a country where depositors have not lost their deposits to their banks (i.e. in a country where people trust their banks). But we all know this is not the case with Argentina. However, I can imagine that the 4% coupon of the certificates will not carved in stone. Would a 20% interest on USD certificates encourage certificate holders to leave them in deposit? It did in 2001, and with Argentina’s holdouts still alive and fighting, this alternative scheme would allow the government to source US dollars and keep kicking the can until the next election.

Nevertheless, with an ever increasing fiscal deficit, it would take an equally growing amount of leverage (on the bonds) to keep the party going. But remember: This whole intellectual exercise is based on the assumption that the bonds trade in the secondary market and that one can only produce a tax moratorium every few years….

If the “bancos” had to offer a high interest rate to use the bonds as collateral (say, above 20% or most likely above the actual inflation rate), the Banco Central (i.e. not the Federal Government that issues the 4% bonds) would feel tempted to directly subsidize the banks, while earning a laughable amount, from its US dollar bills. This subsidy would be required to maintain a positive net interest margin, because I doubt that the bancos would be able to make any significant USD loans at such rates. There is a precedent to this in the Cuenta de Regulación Monetaria, established in 1977.

We can now see that the sustainability of the manipulation in a segmented/broken foreign exchange market causes a negative carry, which would create a quasi-fiscal deficit in Argentina (i.e. the deficit of the Banco Central), fully opening the gates to hyperinflation. I have made the point in earlier letters (here) that the same could be conceived to happen with the manipulation in the price of gold. This latest example from Argentina serves therefore as another experiment in the history of failed manipulations.

One last comment: Because the scheme is so visibly unsustainable, the temporary drop in the price of US dollar bills (i.e. physical US dollars) will attract a higher demand of said US dollar bills, forcing the leverage provided by the certificates to grow exponentially. In the week of the announcement, USD deposits fell another 96 million. This is the same behaviour seen in physical gold.

What makes the gold market of 2013 different?

As gold is a commodity, there is no counterparty risk: Either the gold is or isn’t where it is supposed to be. This makes the gold market less flexible than, say the foreign exchange market just described above. Why? There cannot be an interest rate in gold paper that will keep investors in the Ponzi scheme, just like there is one for US dollar bonds in Argentina.

For instance, if a gold ETF (or any commodity ETF for this purpose) offered a coupon, it would raise all kinds of suspicions, unless we are in a system where gold is allowed to compete with legal tender, in which case too, there would not be a need for gold ETFs. This means that in order to keep its price suppressed, the gold market requires outright fraud. It also means that the only way that such fraud can be resolved is with plain and swift confiscation, because once revealed, no interest rate will clear the market.

If it is correct, as reported, that 1 out of every 15 US dollar bills is held by an Argentine, it is easy to see why the retail US dollar investor in Argentina managed to break the market and keep the official manipulation at bay. This is not the case with the global gold market today, but it was certainly not the case in Argentina of the ‘70s either, when the decline of its economy began to show itself as evident.

Martin Sibileau

With equity valuations no longer levitating but in a different, 4^th dimension altogether, and credit spreads compressing… Which fiduciary portfolio manager can still afford to hedge? Any price to hedge seems expensive and with no demand, the price of protection falls almost daily. The CDX NA IG20 index (i.e. the investment grade credit default swap index series 20, tracking the credit risk of 125 North American investment grade companies in the credit default swap market) closed the week at 70-71bps. The index was at this level back in the spring of 2005. By the summer of 2007, any credit portfolio manager that would have wanted to cautiously hedge with this index would have seen a further compression of 75% in spreads, completely wiping him/her out.

It is in situations like these, when the crash comes, that the proverbial run for liquidity forces central banks to coordinate liquidity injections. However, something tells me that this time, the trick won’t work. In anticipation to the next and perhaps final attempt, I want to offer today an historical perspective on the favorite liquidity injection tool:  Currency swaps. These coordinated interventions are not a solution to the crashes, but their cause, within a game of chicken and egg. But I’ve just given you the conclusion. I need to back it now…

How it all began

Let me clarify: By currency swaps, I refer to a transaction carried out between two central banks. This means that currency swaps cannot be older than the central banks that extend them. On the other hand, foreign exchange swaps between corporations may date back to the late Middle Ages, when trade began to resurface in the Italian cities and the Hansastädte. Having said this, I believe that currency swaps were born in 1922, during the International Monetary Conference that took place in Geneva. This conference marked the beginning of the Gold Exchange Standard, with the goal of stabilizing exchange rates (in terms of gold) back to the pre-World War I.

According to Prof. Giovanni B. Pittaluga (Univ. di Genova), there were two key resolutions from the conference, which opened the door to currency swaps. Resolution No. 9 proposed that central banks “…centralise and coordinate the demand for gold, and so avoid those wide fluctuations in the purchasing power of gold which might otherwise result from the simultaneous and competitive efforts of a number of countries to secure metallic reserves…”

Resolution No. 9 also spelled how the cooperation among central banks would work, which “…should embody some means of economizing the use of gold maintaining reserves in the form of foreign balance, such, for example, as the gold exchange standard or an international clearing system…”

In Resolution No. 11, we learn that: “…The convention will thus be based on a gold exchange standard.” (…) “…A participating country, in addition to any gold reserve held at home, may maintain in any other participating country reserves of approved assets in the form of bank balances, bills, short-term Securities, or other suitable liquid assets…. when progress permits, certain of the participating countries will establish a free market in gold and thus become gold centers”.

Lastly, gold or foreign exchange would back no less than 40% of the monetary base of central banks. With this agreement, the stage was set to manipulate liquidity in a coordinated way to a degree the world had never witnessed before. The reserve multiplier, composed by gold and foreign exchange could be “managed” and through an international clearing system, it could be managed globally.

How adjustments worked under the Gold Standard

Before 1922, adjustments within the Gold Standard involved the free movement of gold. In the figure below, I show what an adjustment would have looked like, as the United States underwent a balance of trade deficit, for instance:

Gold would have left the United States, reducing the asset side of the balance sheet of the Federal Reserve. Matching this movement, the monetary base (i.e. US dollars) would have fallen too. The gold would have eventually entered the balance sheet of the Banque of France, which would have issue a corresponding marginal amount of French Francs.

It is worth noting that the interest rate, in gold, would have increased in the United States, providing a stabilizing/balancing mechanism, to repatriate the gold that originally left, thanks to arbitraging opportunities. As Brendan Brown (Head of Economic Research at Mitsubishi UFJ Securities International) explained (here), with free determination of interest rates and even considerable price fluctuations, agents in this system had the legitimate expectation that key relative prices would return to a “perpetual” level. This expectation provided “…the negative real interest rate which Bernanke so desperately tries to create today with hyped inflation expectations…”

There is an excellent work on the mechanics of this adjustment published by Mary Tone Rodgers and Berry K. Wilson, with regards to the Panic of 1907 (see here). The authors sustain that the gold flows that ensued from Europe into the United States provided the liquidity necessary to mitigate the panic, without the need of intervention.  This success in reducing systemic risk was due to the existence of US corporate bonds (mainly from railroads) with coupon and principal payable in gold, in bearer or registered form (at the option of the holder) that facilitated transferability, tradable jointly in the US and European exchanges, and within a payment system operating largely out of reach from banksters outside of the bank clearinghouse systems. The official story is that the system was saved by a $25MM JPM-led pool of liquidity injected to the call loan market.

How adjustments worked under the Gold Exchange Standard

During the 1920s and particularly with the stock imbalances resulting from World War I, the search for sustainable financing of reparation payments began. Complicating things, the beginning of this decade saw the hyper inflationary processes in Germany and Hungary. By 1924, England and the United States rolled out the Dawes Plan and between 1926 and 1928, the so called Poincaré Stabilization Plan in France. The former got Charles G. Dawes the Nobel Prize Peace, in 1925.

As the figure below shows, against a stable stock of gold, fiat currency would be loaned between central banks. In the case of a swap for the Banque de France, US dollars would be available/loaned, which were supposedly backed by gold. The reserve multiplier vs. gold expanded, of course:

With these transactions central banks would now be able to influence monetary (i.e. paper) interest rates. The balancing mechanism provided by gold interest rate differentials had been lost. As we saw under the Gold Standard before, an outflow of US dollars would have caused US dollar rates to rise, impacting on the purchasing power of Americans. Now, the reserve multiplier versus gold expanded and the purchasing power of the nation that provided the financing was left untouched. The US dollar would depreciate (on the margin and ceteris paribus) against the countries benefiting from these swaps. Inflation was exported therefore from the issuing nation (USA) to the receiving nations (Europe). The party lasted until 1931, when the collapse of the KreditAnstalt triggered a unanimous wave of deflation.

How the perspective changed as the US became a debtor nation

Fast forward to 1965, two decades after World War II, and currency swaps are no longer seen as a tool to temporarily “stabilize” the financing of flows, like balance of trade deficits or war reparation payments, but stocks of debt. By 1965, central bankers are already worried with the creation of reserve assets, just like they are today; with the creation of collateral (see this great post by Zerohedge on the latter).

Indeed, 48 years ago, the Group of Ten presented what was called the Ossola Report, after Rinaldo Ossola, chairman of the study group involved in its preparation and also vice-chairman of the Bank of Italy. This report was specifically concerned with the creation of reserve assets. At least back then, gold was still considered to be one of them. In an amazing confession (although the document was initially restricted), the Ossola Group explicitly declared that the problem “…arises from the considered expectation that the future flow of gold into reserves cannot be prudently relied upon to meet all needs for an expansion of reserves associated with a growing volume of world trade and payments and that the contribution of dollar holdings to the growth of reserves seems unlikely to continue as in the past…”

Currency swaps were once again considered part of the solution. Under the so called “currency assets”, the swaps were included by the Ossola Group, as a useful tool for the creation of alternative reserves. Three months, during a Hearing before the Subcommittee on National Security and International Operations, William McChesney Martin, Jr., at that time Chairman of the Board of Governors of the Federal Reserve System, acknowledged a much greater role to currency swaps, in maintaining the role of the US dollar as the global reserve currency.

In McChesney Martin’s words: “…Under the swap agreements, both the System (i.e. Federal Reserve System) and its partners make drawings only for the purpose of counteracting the effects on exchange markets and reserve positions of temporary or transitional fluctuations in payments flows. About half of the drawings ever made by the System, and most of the drawings made by foreign central banks, have been repaid within three months; nearly 90 per cent of the recent drawings made by the System and 100 per cent of the drawings made by foreign central banks have been repaid within six months. In any event, no drawing is permitted to remain outstanding for more than twelve months. This policy ensures that drawings will be made, either by the System or by a foreign central, bank, only for temporary purposes and not for the purpose of financing a persistent payments deficit. In all swap arrangements both parties are fully protected from the danger of exchange-rate fluctuations. If a foreign central bank draws dollars, its obligation to repay dollars would not be altered if in the meantime its currency were devalued. Moreover, the drawings are exchanges of currencies rather than credits. For instance, if, say, the National Bank of Belgium draws dollars, the System receives the equivalent in Belgian francs; and since the National Bank of Belgium has to make repayment in dollars, the System is at all times protected from any possibility of loss. Obviously, the same protection is given to foreign central banks whenever the System draws a foreign currency.

The interest rates for drawings are identical for both parties. Hence, until one party disburses the currency drawn, there is no net interest burden for either party. Amounts drawn and actually disbursed incur an interest cost, needless to say; the interest charge is generally close to the U.S. Treasury bill rate…”

My graph below should help visualize the mechanism:

Essentially, with these currency swaps, foreign central banks that during the war had shifted their gold to the USA, became middlemen of a product that was a first-degree derivative of the US dollar, and a second-degree derivative of gold.

On September 24^th 1965, someone called this Ponzi scheme out. In an article published by Le Monde, Jacques Rueff publicly responded to this nonsense, under the hilarious title “Des plans d’irrigation pendant le déluge” (i.e. Irrigation plans during the flood). He minced no words and wrote:

“…C’est un euphénisme inacceptable et une scandaleuse hyprocrisie que de qualifier de création de “liquidités internationales” les multiples operations, tells que (currency) swaps…” “C’est commetre une fraude de meme nature que de présenter comme la consequence d’une insuffiscance générale de liquidités l’insufficance des moyens dont disposent les Etats-Unis et l’Anglaterre pour le réglement de leur déficit exterieur”

My translation: “…It is an unacceptable euphemism and an outrageous hypocrisy to qualify as creation of “international liquidity” multiple transactions, like (currency) swaps…”…“…In the same fashion, it is a fraud to present as the consequence of a general lack of liquidity, the lack of means available to the USA and England to settle their external deficits…”

Comparing the USA and England to underdeveloped countries, Rueff added that these also lack external resources, but those that are needed cannot be provided to them but by credit operations, rather than the superstition of a monetary invention disguised as necessary and in the general interest of the public (i.e. rest of the world).

With impressive prediction, Rueff warned that the problem would present itself in all its greatness, the day these two countries decide to recover their financial independence by reimbursing with their dangerous liabilities (i.e. currencies). That day, said Rueff, international coordination would be necessary and legitimate. But such coordination would not revolve around the creation of alternative instruments of reserve, demanded by a starving-for-liquidity world.  That day would be a day of liquidation, where debtors and creditors would be equally interested and would share the common responsibility of the lightness with which they jointly accepted the monetary difficulties that are present….Sadly, Rueff’s call could not sound more familiar to the observer in 2013…

How adjustments work today, without currency swaps

Until the end of the Gold Exchange Standard, even if the reserve multiplier suppressed the value of gold (like today), gold was still the ultimate reserve and had in itself no counterparty risk. After August 15^th, 1971, when Nixon issued the Executive Order 11615 (watch announcement here), the ultimate reserve was simply cash (i.e. US dollars) or its counterpart, US Treasuries. And unlike gold, these reserve assets could be created or destroyed ex-nihilo. When they are re-hypothecated, leverage grows unlimited and when their value falls, valuations dive unstoppable. Because (and unlike in 1907) the transmission channel for these reserves today is the banking system, when they become scarce, counterparty risk morphs into systemic risk.

When Rueff discussed currency swaps, he had imbalances in mind. In the 21^st century, we no longer have time to worry about these superfluous things. Balance of trade deficits? Current account deficits? Fiscal deficits? In the 21^st century, we cannot afford to see the big picture. We can only see the “here and now”. Therefore, when we talk about currency swaps, the only thing we have in mind is counterparty risk within the financial system. The thermometer that measures such risk is the Eurodollar swap basis, shown below (source: Bloomberg). As the US dollar became the carry currency, the cost of accessing to it became the cornerstone of value for the rest of the asset spectrum, widely known as “risk”.

In the chat below, we can see two big gaps in the Eurodollar swap basis. The one in 2008 corresponds to the Lehman event. The one in 2011 corresponds to the banking crisis in the Eurozone that was contained with a reduction in the cost of USDEUR swaps and with the Long-Term Refinancing Operations done by the European Central Bank. In both events, the financial system was in danger and banks were forced to delever. How would the adjustment process have worked, had there not been currency swaps to extend?

In the figure below, I explain the adjustment process, in the absence of a currency swap. As we see in step 1, given the default risk of sovereign debt held by Eurozone banks, capital leaves the Eurozone, appreciating the US dollar. We see loan loss reserves increase (bringing the aggregate value of assets and equity down). As these banks have liabilities in US dollars and take deposits in Euros, this mismatch and the devaluation of the Euro deteriorates their risk profile

Eurozone banks are forced to sell US dollar loans, shown on step 2. As they sell them below par, the banks have to book losses. The non-Eurozone banks that purchase these loans cannot book immediate gains. We live in a fiat currency world, and banks simply let their loans amortize; there’s no mark to market. With these purchases, capital re-enters the Eurozone, depreciating the US dollar. In the end, there is no credit crunch. As long as this process is left to the market to work itself out smoothly, borrowers don’t suffer, because ownership of the loans is simply transferred. This is neutral to sovereign risk, but going forward, if the sovereigns don’t improve their risk profile, lending capacity will be constrained.

In the end, an adjustment takes place in (a) the foreign exchange market, (b) the value of the bank capital of Eurozone banks, and (c) the amount of capital being transferred from outside the Eurozone into the Eurozone.

How adjustments work today, with currency swaps

Let’s now proceed to examine the adjustment –or better said, lack thereof- in the presence of currency swaps. The adjustment is delayed. In the figure below, we can see that the Fed intervenes indirectly, lending to Eurozone banks through the ECB. Capital does not leave the US. Dollars are printed instead and the US dollar depreciates. On November 30th, of 2011, upon the Fed’s announcement at 8am, the Euro gained two cents vs. the US dollar. As no capital is transferred, no further savings are required to sustain the Eurozone and the misallocation of resources continues, because no loans are sold. This is bullish of sovereign risk. The Fed becomes a creditor of the Eurozone. If systemic risk deteriorates in the Eurozone, the Fed is forced to first keep reducing the cost of the swaps and later to roll them indefinitely, as long as there is a European Central Bank as a counterparty for the Fed, to avoid an increase in interest rates in the US dollar funding market. But if the Euro zone broke up, there would not be any “safe” counterparty –at least in the short term- for the Fed to lend US dollars to. In the presence of a European central bank, the swaps would be bullish for gold. In the absence of one, the difficulty in establishing swap lines would temporarily be very bearish for gold (and the rest of the asset spectrum).

Final words

Over almost a century, we have witnessed the slow and progressive destruction of the best global mechanism available to cooperate in the creation and allocation of resources. This process began with the loss of the ability to address flow imbalances (i.e. savings, trade). After the World Wars, it became clear that we had also lost the ability to address stock imbalances, and by 1971 we ensured that any price flexibility left to reset the system in the face of an adjustment would be wiped out too. This occurred in two steps: First at a global level, with the irredeemability of gold: The world could no longer devalue. Second, at a local and inter-temporal level, with zero interest rates: Countries can no longer produce consumption adjustments. From this moment, adjustments can only make way through a growing series of global systemic risk events with increasingly relevant consequences. Swaps, as a tool, will no longer be able to face the upcoming challenges. When this fact finally sets in, governments will be forced to resort directly to basic asset confiscation. 

Martin Sibileau

In the past months and right after implementing Quantitative Easing Unlimited Edition, the Fed began surfacing the idea that an exit strategy is at the door. With the latest releases of weak activity data worldwide, the idea was put back in the closet. However, a few analysts have already discussed the implications of the smoothest of all exit strategies: An exit without asset sales; a buy & hold exit. I have no doubt that as soon as allowed, the idea will resurface again.

Underlying all official discussions is the notion that an exit strategy is a “stock”, rather than a flow problem, that the Fed can make decisions independently of the fiscal situation of the US and that international coordination can be ignored. This is logically inconsistent and today’s letter will address these inconsistencies. Let’s see…

Monetary expansions are treated as a flow process

Conventional PhD wisdom on monetary things tells us that government deficits represent net credits to the system via reserves, as well as to non-government deposits at banks.

Visually:

When it comes to bond purchases by the Fed, such wisdom implies that the US Treasury is assisting markets with liquidity. This is not new. As a student, I once heard that “governments must run deficits, so that markets can have a benchmark rate”. My professor meant that “thanks” to fiscal deficits, bonds are issued and markets can proceed with the price discovering process. Today of course, we don’t even have that luxury, courtesy of Quantitative Easing (Not happy with the lesson, I asked Dr. Julio H. Olivera his thoughts on this statement. He chuckled (although Dr. Olivera never really chuckled) and recalled a similar exchange with  John Hicks. According to Dr. Olivera, when Hicks was faced with the same proposition, he replied: “The merchant makes the market”. Unfortunately, I cannot prove this exchange, but thought I would share it with you).

But monetary contractions are treated as a stock problem

Why do I bring this up? Because if deficits are welcome by the PhD standard when it comes to monetary expansions, surpluses should not be ignored, when dealing with monetary exit strategies. It’s only fair…Yet, in the past months there has been a timid incursion into the upcoming debate on exit strategies available to the Fed, but without a single comment on fiscal policies. By now, I have become used to typing CTRL+F “fiscal” (i.e. find “fiscal”), whenever I come across any research note on potential exit strategies. If nothing comes up, it looks suspicious to me.

Once such example was Bank of America’s April 10^th note titled “The consequences of a “no sales” Fed exit strategy”, from the Global Economics Rates & FX team. This paper has not a single sentence or thought on the fiscal situation and Treasury issuance forecasts of the United States (the word “fiscal” only shows up once). They are not alone. How can mainstream economics afford to ignore the fiscal side of the problem when facing an exit strategy? They simply treat it as a “stock”, rather than a flow problem.

Terms of the “stock” perspective

As a stock problem, mainstream economists look at a “no sales” exit strategy by the Fed, in these terms:

1.-Not to sell means to hold, while principal and interest payments are reinvested.

2.-The target of a 6.5% unemployment rate is reached and there are signs of a firm recovery underway

3.-Losses on their US Treasuries portfolio are manageable, particularly since the Fed announced its accounting policy change on January 6^th 2011, where capital losses may be treated as negative liabilities (Truly, you can’t make this stuff up).  Even putting this fiction away, mainstream analysis is comfortable with a negative impact on the asset side of the Fed’s balance sheet. To assess that impact, reference is made in terms of 10-yr equivalent duration exposure held outside of the Fed. Growth of 10-yr equivalents is expected to stabilize. As I mentioned in the last letter on the Bank of Japan, I side with Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, who argue that volatility in the Japanese bond market could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, the market does not look at the stock of government debt as a block of exposure that is sizable in equivalent duration terms.

4.-Reserves management, via interest on reserves, can be used to send short-term signals to the market.

In the next sections, I will seek to demonstrate that it is a huge mistake to ignore the fiscal side of this dynamic picture, and that a smooth, no sales exit strategy is fiction. Moreover, I will show that this is a flow, rather than a stock problem. Before I proceed, let me offer you this interesting exchange between Stanley Druckenmiller and Kevin Warsh, which took place on March 5th (Druckenmiller’s intervention starts on minute 5:41)

The flow perspective of the “no sales” exit strategy

To simplify the exposition, let’s look at the cash flow situation of the US government. Like any of us, the government has to collect taxes and pay for expenses. For this particular discussion, it will not matter if the same are ordinary, extraordinary, operating, capital expenditures etc. All I want to do here is to separate this collection of taxes net of expenses –which I will call Primary Cash flow- from the cash flow that has to be used to service debt obligations. In other words, like any of us, the US government will have, after collecting taxes and paying expenses, a primary cash flow with which to service debt obligations:

If the Primary Cash flow (PCF) is not enough to service the debt, unlike us, the government can issue more debt (at least the US government; at least for now). Additionally, the government can liquidate assets. Therefore:

Let’s now look at the demand for the gross issuance and simplify it, saying that the same is purchased either by the Fed, by the rest of the central banks in the world, and by the rest of the world (ROW, i.e. anyone else in this planet who is not a central bank, either in the public or private sector). Under these terms:

Let’s assume that the government sells no assets. If the Fed stopped purchasing US sovereign debt but did not sell any holdings and kept reinvesting the interest and principal payments it received, re-arranging the terms, we obtain:

Let’s further call a Net Demand of one of the agents (i.e. central banks, rest of the world) the difference between its purchases and the collected interest and debt repayments. We can then say that under a “no sales” exit strategy of the Fed and without asset sales, the primary cash flow of the US government equals the sum of the net demands of the central banks and the rest of the world. This is valid at one point in time as well as when we consider the comparative statics of the issue (the term “D” below denotes temporal change in a variable, between t and t+1):

Having arrived to the identity above (the above notations are identities, not equations), let’s look at the context under which the “no sales” strategy would take place. It is a context of a firm recovery, as the Fed has told us and we have every grounds to believe that for this reason, interest rates would tend to rise, as capital moves out of fixed income and credit, into equities. This means that the Net Demand of US Treasuries by the Rest of the World will likely be negative (i.e. Drucknemiller’s observation) or zero, at best:

Let’s take the optimistic view that the Net Demand of the Rest of the World is zero (Clearly, Mr. Druckenmiller does not share this view…and he has every reason not to be). This means that if neither the Fed nor the Rest of the World add US Treasuries to their balance sheets, the primary cash flow of the US government has to be addressed by the Net Demand of central banks, exclusively.

We can think of three different scenarios for the primary cash flow of the US government: A scenario of surpluses (PCF >0), deficits (PCF <0) or balance (PCF = 0).

If the primary cash flow is negative

This is the toughest scenario. It implies that the negative primary cash flow of the US government will be financed by the central banks of the rest of the world. The question here is: Why would these central banks keep accumulating US Treasuries when the Fed itself does not? From here, it is very clear to me that in the presence of continuing fiscal deficits, regardless of where the unemployment rate is, the Fed has no alternative but to continue monetizing the deficits.

But let’s examine this case further. Let’s suppose that by some miraculous intervention, the central banks of the rest of the world would in fact resolve to continue purchasing US sovereign debt, even if the Fed itself wouldn’t. How would this process take place?

There are two ways. Either the currency zones these central banks operate in generate balance of trade surpluses or their respective nations incur into fiscal deficits.

In my last letter, I explained how the latter way worked in Japan under Shirakawa. With regards to the former, to expect a sustainable recovery in the United States (which is the a priori condition for an exit) within a context of fiscal deficits, increasing sovereign debt and balance of trade deficits is a contradiction. Yet some mainstream economists see this as something very feasible, whereby the Debt/GDP ratio falls because the denominator rises faster than the numerator. If this is true, then I am completely wrong and I have nothing else to say. If you believe in the sustainability of this context, please accept my apologies for having taken your time. If you don’t, please proceed to the next scenario analysis.

If the primary cash flow is positive

If the primary cash flow was positive, the Net Demand of the rest of the central banks would be negative.  This would imply a strong and positive savings rate in the United States. The problem is to figure out how the United States can get to achieve a savings rate strong enough to get to this point, in a context of negative to zero interest rates, where nobody has any incentive to save and where the same Fed wants to boost consumption. I asked about this problem (i.e. how the savings rate will improve) to a very well-known economist who gave a presentation this past Wednesday April 24^th, at the Oakville Community Foundation. His answer was that the stronger savings rate would come from the public sector. But this explanation seems to me a tautology (i.e. The US government will be cash flow positive because it will save)

The real question in the face of this problem is “What will push the US government and the US to save, when all its deficits are monetized and interest rates are negative?” This is not a new question. In fact, it occupied the mind of Jacques Rueff for decades. Perhaps the first time M. Rueff made public this concern was during an exchange with no other than the same John Maynard Keynes in 1929, during a conference at the Assembly of the League of Nations, in Geneva. M. Rueff suggested that there was indeed an adjustment mechanism for the balance of trade and Keynes asked how such an adjustment could be brought about.

Rueff explained that inflation is nothing else but the creation of purchasing power in a country without a counterpart increase in production. For that reason, it is only possible to run balance of trade deficits indefinitely –like the US has done over the 20^th and 21^st centuries- if there is inflation. The opposite should also be true: In the absence of inflation, there would be a balance of trade surplus, until all debts are paid (as in this scenario, where the Net Demand of the rest of the central banks is negative).

In summary, to effect a negative Net Demand of the rest of the central banks in US Treasuries, the purchasing power of Americans should be decreased. But how will the United States ever achieve such a state of affairs, when the Fed targets a 6.5% unemployment rate precisely by inflating the purchasing power of Americans? If the Fed is successful, the opposite will have occurred and the nominal purchasing power of Americans will have increased. Therefore, a positive primary cash flow is not possible, as long as the Fed continues boosting asset prices.

How did Keynes react to this view? We have only the testimony of Jacques Rueff on this, which I reproduce below:

“…Et Keynes, qui marchait de long en large –c’était sur la scène d’un théâtre- s’est arrêté brusquement et a dit: “Tiens, mais, cela c’est une idée intéressante, il faudra que j’y réflechisse.”

Je dis cela à mon ami Largentaye, parce que c’est très important pour l’historie de la pensée keynesienne. Cela prouve qu’en 1929 la théorie de la dépense global n’était pas encore au point dans son (i.e. Keynes’) esprit et que c’est plus tard, dans l’ouvrage que M. de Largentaye a traduit, qu’elle s’est élaborée, d’abord dans le Traité sur la monnaie et, ensuite, dans la Théorie générale. Et cela indique, d’ailleurs, le caractère mouvant de sa pensée; ce n’est pas une critique que je lui adresse, c’est plutôt un éloge; c’était un des esprits les plus actifs qui fût…” (J. Rueff, Le système monétaire international”, presentation given at the Conseil Economique et Social, May 18^th, 1965).

Finally, if the nominal purchasing power of Americans will not be decreased by the Fed, the real purchasing power will have to fall, with the devaluation of the US dollar. This is a logical conclusion. In a context of global monetary easing, this can only be achieved against gold and…. why not, commodities in general.

If the primary cash flow is zero

This is a simple theoretical conjecture, just like the existence of general equilibrium in the fractionary reserve system and shadow banking we live in. To discuss it is an intellectual exercise of dubious utility.

Conclusions

In this discussion, I sought to show that:

-The exit strategy of the Fed is not a stock, but a flow problem.

-Just like expansionary monetary policy must address fiscal policy, contractionary monetary policy cannot ignore fiscal deficits.

-The fiscal issue PRECEDES the monetary issue. Without first addressing fiscal policy, it is irrelevant whether or not a labour market objective is achieved (i.e. unemployment rate of 6.5%).

-Any analysis of a potential exit by the Fed that dismisses fiscal deficits and focuses on the management of the balance sheet of the Fed only is surreal. It is not enough to claim that buy & hold is better than selling.

-In the case of the Fed, international coordination is required for an exit strategy to succeed.

Bonus: Was Mr. Druckenmiller correct?

As you may have noticed, I was optimistic and assumed that the Net Demand of US Treasuries by central banks would increase (i.e. international coordination) and that the Net Demand of the Rest of the World would remain unchanged.

What I believe Mr. Druckenmiller had in mind is a more realistic picture, where the Net Demand of the central banks would remain unchanged, while that of the Rest of the World becomes increasingly negative. In this context, with the US government continuing to run negative primary cash flows and the Fed shifting from quantitative easing to a buy & hold stance, the supply of US Treasuries would increase and interest rates would rise exponentially. Mr. Druckenmiller was correct.

Martin Sibileau

Over the past week, I had three main topics in my mind. Perhaps, I should have considered more, but these are them: The plunge of precious metals, the policy of the Bank of Japan, and the debate on the Fed exit tools. I don’t want to write about the latest manipulation of the precious metals, but I have to say that I came across what seemed to me a lot of nonsense.  Maybe the weakest explanation is the one that simply states that “a correction was due”. And this explanation does not only come from those who don’t believe in gold. You have Marc Faber and Jim Rogers giving it too.

Below is a chart I used in a past letter. It shows the value of the US dollar in terms of Argentine pesos, both in the official and black market (blue line).

How do you think an Argentinian would react if I told him that the blue line is “due for a correction”? He would obviously laugh at me without mercy. Why can he afford to laugh at me? Because the US dollar market in Argentina is broken, and the paper USD market (i.e. certificates of deposit in US dollars), is no longer driving the market dynamic. The USD market in Argentina can therefore not be manipulated. It is driven by physical USD bills hidden under mattresses.

What about the value of the Deutsche Mark in gold during the ‘20s or the Yugoslavian dinar, in USDs, during the early ‘90s? Were those also not due for a correction? (charts below)….Just askin’…..

Technical analysis, both when the markets are broken (as in Argentina, Germany in the 1920’s or Yugoslavia in the ‘90s) or when they are rigged, is useless.

Let’s now concentrate on the events out of Japan. I know I am late to the party but after reading volumes of comments on this, I feel there is still something to be written. Most publications were limited to simply enumerating the changes in policy of the Bank of Japan (BOJ), while others just pointed out immediate, tactical consequences (i.e. volatility in Japanese Government Bonds, JGBs)…and then…then we had Robert Feldman, from Morgan Stanley, telling us that  Japan may still be saved.

The main take away for me is that the BOJ shifted from a tactic of interventions (under former Governor Masaaki Shirakawa) to one of monetary policy (under current Governor Haruhiko Kuroda) . What strikes me is that the monetary policy is precisely to….well, destroy their money and in the process any chance of having a monetary policy.

How the Shirakawa intervention worked

In Japan, the FX intervention is carried out by the Ministry of Finance, rather than the Bank of Japan. In order to sell Yen to the FX market to devalue, under Shirakawa, the Ministry of Finance issued Finance Bills, which were “bought” by the Bank of Japan, in Yen. Let’s call these first issues Finance Bills “1” and Yen “1”, which were issued by the Ministry of Finance and the Bank of Japan, respectively, as shown in the graph below (step 1). The Ministry of Finance was issuing “on credit”, because the issuance was going to later be repaid with funds obtained from the market:

Next, with the Yen1, the Ministry of Japan bought USDs in the FX market (step 2). The price of Yen in terms of USDs dropped as its supply increased.  At this point, the amount of Yen circulating in the market was higher than before this intervention took place. This increase in supply is the amount I call Yen1.

To bring the supply of Yen back to the original amount in circulation, the Ministry of Finance issued Finance bills in the market. I will call this issuance Finance Bills 2, which are shown below (step 3). The amount of Finance Bills 2 equaled that of the first issuance, Finance Bills 1, and raises Yen2, so that Yen1=Yen2:

Of course, as the Ministry of Finance went to the market to place Finance Bills 2, with this new issuance, the supply of government debt in Yen increased. As in any other bond market, as supply grew, yields tended to rise (i.e. price tended to fall), to encourage market participants to buy the increased supply.

Once the amount Yen2 was in the balance sheet of the Ministry of Finance, the Ministry used it to repay its outstanding debt with the Bank of Japan, which I called Finance Bills 1. Therefore, once this payment was done (with a lag), the balance sheet of the Bank of Japan remained unchanged and Yen1 were taken out of circulation. The Ministry of Finance had US dollars on the asset side of its balance sheet, matched by Finance Bills 2 on the liabilities side, as shown in the graph below (step 4):

The graphs above show the balance sheets of all the participants in this intervention: The Ministry of Finance, the Bank of Japan, the FX market and the Yen Government debt market. But it is also be interesting to show the intervention in terms of cash flows. In the graph below, we can see that de facto, the Ministry of Finance ended up as intermediary between the Government debt market and the FX market. In essence, the intervention “moved” Yen from the Government debt market to the FX market, and this was a “fragile” movement, because it was simple arbitrage.

Whenever an asset has two different prices, arbitrage arises and fixes the “anomaly”. You may wonder why I imply that the Yen had two different prices. I want answer with another question: Why would the JGB market need a “middle-man” (see graph below) to provide Yen to the FX market? It didn’t!

The JGB market was “not willing” to buy US dollars (i.e. provide Yen) from the FX market at a loss (i.e. buying US dollars at above market prices). Who ended up taking the loss? Who ended up buying US dollars at above 80-82 Yen per dollar? The Ministry of Finance did, which meant the average Japanese tax payer! The Japanese taxpayer subsidized the big exporting conglomerates of Japan, so that these would provide “financing” to the American consumer who remains broke. The subsidy was significant because as we saw in the graphs above, two things take place simultaneously: a) Interest rates in Yen would tend to increase (i.e. price of Yen Finance Bills will tend to fall) and b) the holders of Yen (i.e. Japanese consumer) lost purchasing power. Given the demand for JGBs, the temporary nature of the interventions (which did not shape inflation expectations) and the short-term of the debt purchased, the marginal effect of issuing Finance bills 2 was not relevant (i.e. on interest rates).

In the long term, with these interventions, the Ministry of Finance had P&L risk (i.e. the risk of having a loss, if the USD depreciates further) which could only be addressed with higher debt (i.e. higher interest rates) or higher taxes. Under intervention, the Profit/Loss position of the Ministry of Finance was determined by:

P&L = D US dollars (in its Assets) / D t – D Finance Bills 2 / D t

Whenever the Fed undertook quantitative easing and the value of the US dollar fell, it generated a negative mark-to-market to the Ministry of Finance’s position (if they indeed mark themselves to market).

How the Kuroda policy works

Under Mr. Kuroda’s leadership, the BOJ will not be manipulating interest rates (i.e. price), but will target the monetary base (i.e. volume). The problem is that he pretends to be in control of both, when the fact is that this ancient truth holds: One can only control price or volume, but not both simultaneously.

The new policy consists of:

1.- Increasing the monetary base at an annual speed of JPY60-70 trillion (stock of JPY200 trillion by Dec/13 and JPY 270 trillion by Dec/14).

2.- To accomplish No. 1, the BOJ will purchase approx. JPY7 trillion in JGBs/month, on a gross basis. On a net basis (i.e. net of repayments), holdings of JGBs will rise by JPY50 trillion/year.

3.- JGBs purchased will include long-term issues (incl. 40-year, previously limited to 3-year maturities), raising the average remaining tenor of the BOJ holdings from 3 to about 7 years.

4.- Achieving a 2% inflation level as soon as possible

5.-Purchases will include also ETFs and REITs (Japanese)

With the Shirakawa intervention the market had to assume that the devaluing efforts were temporary, or at least not within a specific time frame, and consistent with a policy of keeping interest rates at zero. Challenging the BOJ was a frustrating experience. Under Mr. Kuroda however (and here is where I disagree with mainstream analysis), Japan is entering the uncharted waters of a Latin American-style inflationary spiral (very similar to the plan implemented by the late Martinez de Hoz, also called “La Tablita”).

The chart below shows the balance sheets of the involved economic agents:

As you can see, there is nothing fancy here. Given the magnitude of the monetary expansion, what is a big unknown is what will the net aggregate reallocation of JGB holdings be, outside the Ministry of Finance. Because the BOJ will not only buy issuance of the Ministry of Finance, but also existing stock of JGBs. For now, it is all speculation and the flows are monitored closely. The reader will find plenty of research material on where Japanese banks, pensions, insurers and households will reallocate the JGBs that they sell (if they sell them). I think they are and will be exponentially selling them, because the pace of the devaluation in the Yen will generate tangible profits to those doing so.

When one owns a fixed income asset with a negative interest rate, it is difficult to grasp that purchasing power is being destroyed. The asset is benchmarked against an arbitrary consumer price index. If at the same time there is a certain, known rate of devaluation in the currency of denomination of that asset, there is still difficulty in assessing whether if, in terms of other goods in the same currency (but not in terms of imports), value is being destroyed.

However, there is no doubt that under a known rate of devaluation, if that fixed income asset is swapped for another one denominated in the appreciating currency, there will be a profit. In the case of Kuroda’s policy, because the devaluation is not a one-and-for-all event but a certain, over-no-less-than-2-years process, the devaluation of the yen morphs into a “rate” of appreciation of foreign assets and prices of imported goods.

This rate of appreciation is therefore fungible into another magnitude: Yen-denominated yields. Therefore, a circularity ensues: Yen-denominated yields/spreads will incorporate devaluation expectations. As yields/spreads rise, the Bank of Japan will be forced to buy more JGBs, to keep yields within a level that it deems tolerable. As the BOJ buys more JGBs, the devaluation will likely accelerate.

It is important to understand that this circular, spiraling process can take place regardless of the RELATIVE reallocations done by the Japanese banks, pensions, insurers and households. What matters is that as more Yen is printed, more Yen is available and it devalues vs. the USD. The speed of devaluation will indeed be influenced by the relative reallocations above.

Additional observations on volatility and growth

Kuroda’s policy has and will continue to generate enormous volatility in the JGB market. That same volatility was likely a factor enhancing the effects of the manipulation in gold.

With regards to volatility in JGBs, I found interesting a suggestion made by Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, dated April 11^th. According to the authors, the volatility could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, it would help if the BOJ would improve its communications strategy. What I find of interest in this suggestion is that it is contrary to an increasing common belief regarding exit strategies available to the Fed. Indeed, when it comes to assessing the possible impact of balance sheet management by the Fed, analysts advise that we look at its US Treasury holdings in terms of 10-year duration equivalents. The actual distribution of maturities in the Fed’s holding is perhaps not so relevant. Ironically, this wisdom also comes from the Bank of America, although from a different team (i.e. Brian Smedley, Global Economics Rates & FX, “The consequences of a “no sales” Fed exit strategy”, April 10^th, 2013), as well as from BMO Capital Markets (Dimitri Delis, March 25^th, 2013). Personally, I side with the view of Ohsaki and Fujita: To me, distribution matters as much to the BOJ as it will to the Fed.

With regards to the impact on real growth of the Kuroda’s policy, I cannot mince words: It will be disastrous. Whenever the medium of indirect exchange of a nation is destroyed, no growth can ever be expected. The coordination process needed to allocate resources is seriously impaired. And to explicitly have the central bank tell their people that the monetary base will be doubled within two years is nothing short of destroying their medium of indirect exchange.

For some reason (unknown to me), Robert Feldman (Morgan Stanley, April 4^th and April 17^th, 2013) is more optimistic. He believes that Japan still has a chance, if the country implements what he refers to a “third arrow” policy. Feldman’s third arrow policy is a list of actions that would promote growth, in agriculture, medical care, energy, employment and electoral system….I wonder whether Mr. Feldman seriously asked himself why any initiative in these fields would require that the monetary base of the country be doubled by the end of 2014…

Conclusions

With the interventions under Shirakawa, the Bank of Japan did not need to sterilize, as it is clear from the mechanism previously described. The BOJ’s balance sheet remained unchanged at the end of the intervention. This supposedly meant that the BOJ was independent.  However, given the resulting long USD risk position by the Ministry of Finance (see step 4 above), in the long term, coordination with the Fed would have been required. In my view, it was exactly because the Fed’s (undisclosed) intention was to engage in never ending Quantitative Easing, that Japan was forced to implement the policy undertaken by Kuroda. Coordination with the Fed was impossible.

With Mr. Kuroda’s policy, we now have the BOJ with a balance sheet objective, the Fed with a labour market objective (or so they want us to believe), the European Central Bank with a financial system stability objective (or a Target 2 balance objective) and the People’s Bank of China (and the Bank of Canada) with soft-landing objective . It is clear that any global coordination in monetary policy is completely unfeasible. The only thing central banks are left to coordinate is the suppression of gold.

Martin Sibileau

If I have to summarily describe the events of the past week, I will say that it was the week Modern Monetary Theory won over any other school of thought…(I promise you this: Today’s letter will not be a rant…)

Brief introduction to Modern Monetary Theory

I suggest you do your own research on this topic, because what I will say here is by no means exhaustive. But it is important to be aware of a new reality. I, for one, found a fair summary of it here. Below is a list of some theses held by this school, from L. Randall Wray’s “Modern Monetary Theory: A Primer on Macroeconomics for Sovereign Monetary Systems”(From chapter 18, edited by me):

“Statements that do NOT apply to a currency-issuer:

-Governments have a budget constraint (like households and firms) and have to raise funds through taxing or borrowing

-Government deficits drive interest rates up, crowd out the private sector…and necessarily lead to inflation

-Government deficits leave debt for future generations: government needs to cut spending or tax more today to diminish this burden

-Government deficits take away savings that could be used for investment

-We need savings to finance investment and the government’s deficit

While these statements are consistent with the conventional wisdom, and while they are more-or-less accurate if applied to the case of a government that does not issue its own currency, they do not apply to a currency issuer…”

“…Principles that DO apply to a currency issuer. Let us replace these false statements with propositions that are true of any currency issuing government, even one that operates with a fixed exchange rate regime:

-The government names a unit of account and issues a currency denominated in that unit;

-The government ensures a demand for its currency by imposing a tax liability that can be fulfilled by payment of its currency;

-Government spends by crediting bank reserves and taxes by debiting bank reserves; in this manner, banks act as intermediaries between government and the non government sector, crediting depositor’s accounts as government spends and debiting them when taxes are paid;

-Government deficits mean net credits to banking system reserves and also to non government deposits at banks;

-Central banks set the overnight interest rate target; it adds/drains reserves as needed to hit its target rate;

-The overnight interest rate target is “exogenous”, set by the central bank; the quantity of reserves is “endogenous” determined by the needs and desires of private banks; and the “deposit multiplier” is simply an ex post ratio of reserves to deposits—it is best to think of deposits as expanding endogenously as they “leverage” reserves, but with no predetermined leverage ratio;

-The treasury cooperates with the central bank, providing new bond issues to drain excess reserves, or retiring bonds when banks are short of reserves; for this reason, bond sales are not a borrowing operation used by the sovereign government, instead they are a “reserve maintenance” tool that helps the central bank to hit interest rate targets;

-The treasury can always “afford” anything for sale in its own currency, although government always imposes constraints on its spending; and lending by the central bank is not constrained except through constraints imposed by government (including operational constraints adopted by the central bank itself).

I could discuss at length (and likely shall have to in the future) how I disagree with the statements above, but today it is not relevant. Today, that school of thought won the day and rather than criticism, I believe it merits that we acknowledge its existence and understand its implications.

Historical context of Modern Monetary Theory (MMT)

MMT is to me the 21^st century re-incarnation, in monetary policy, of Cardinal Richelieu’s raison d’état concept. If I am correct, it will bring the same serious consequences it brought in the 17^th century (In his book “Diplomacy”, Henry Kissinger gives Cardinal Richelieu all the credit for this political concept. It is very unfair. About a century earlier, Niccolò Machiavelli dedicated his book “The Prince” precisely to encourage the Medici family to undertake his dream of national unification in Italy. Yet, Kissinger did not devote one single sentence of his book to Machiavelli).

When Cardinal Richelieu thought of état, he thought along the terms most of us can relate to. When Modern Monetary Theory discusses sovereignty, the borders change: We can no longer speak of states, but of fiat currency jurisdictions; and there are only two: The one corresponding to the global reserve fiat currency and the one corresponding to the rest of fiat currencies, which are benchmarked to the global reserve.

Why Modern Monetary Theory won last week

Perhaps to MMT, its raison d’état is its very same existence. When Richelieu (but not Machiavelli) thought about état, he did not think in état as “the” entity in itself. He thought of France, as a particular case. MMT however is universal; its raison d’etat is the survival of fiat currencies, which forces policy makers to cooperate globally in order to destroy any other alternative currencies. In the case of gold, precisely, I methodically proved it in an earlier letter (here).

On April 4^th, we had a strong indication that the raison d’etat was becoming increasingly relevant. During a press conference, Mr. Draghi, answering a question from Zerohedge.com, stated that “… people(…)  vastly underestimate what the Euro means for the Europeans (…); they vastly underestimate the amount of political capital that has been invested in the Euro...”  I thought he was very wrong. I don’t think anyone actually underestimates them, which is why I so fear that this game will end in a war, as unseen unemployment rates are coerced upon millions of innocent families.

Then, last week we saw the evidence of MMT realpolitik at work: First with Bitcoins and then with gold. Both destroyed on no fundamentals. In the case of gold, it even occurred at precisely predicted timing. Because even if Draghi openly did (although in a more subtle way) what Gordon Brown did in May of 1999, the prospect of Cyprus selling its gold had already been made public two days before last Friday (April 12^th). Therefore, this was not a new fundamental. Hence, having not been enough, the typical take down on gold first at 4:00am ET, then at 8:20am and 10:30am ensued (see chart below).

Free, open, markets cannot be anticipated in such way. Yet I can remember pointing out to you the precise timing of these moves in earlier letters (i.e.”… I am tired of seeing endless proof of suppression (i.e. the typical take downs in the price at either 8:20am ET or at 10am-11am ET, with impressive predictability) …February 21, 2013”). Nothing else to add here. If a schmuck like me can tell you months in advance that a market price will fall at 8:20am and 10am and you see that price falling at 8:20am and 10am, then….

Why did bitcoin and gold collapse? (And make no mistake, because gold did collapse). Because they are not redeemable. In the first case,  it is easier to accept this. In the second, most will disagree with me. To those, I answer that as long as the US government can refuse (or get away with refusing) to deliver the physical gold to a central bank the sorts of the Bundesbank, one can safely say that regardless of the marginal bullion held by retail in safety boxes or bullion banks in vaults, for all practical purposes, gold shall be negated. I am deeply disappointed with myself, for not having understood this fact earlier, of course.

There are those who still think China will reveal its true holdings of gold. Personally, I think it is very unlikely. They would be acting against their own interest.

What next? Upcoming challenges to Modern Monetary Theory

As at April 2013, I can see three main challenges to MMT. If they are overcome by MMT, freedom as we know it, will be a thing of the past.  They can be temporarily overcome, with coercion,  and the words of Mr. Draghi at his last press conference are more than ominous in this regard. Times like these have taken place in every century of the history of civilization, and I see no reason to deny the probability of them occurring once again in the 21^st. In no particular order, these are the challenges:

-Annihilating the last bastion of redeemable, alternative marketable value:

After April 13^th, the last bastion of redeemable and alternative market value is in agricultural commodities. Because these are perishable, they cannot be stored away and refused to deliver, like precious metals. Because they cannot be stored away, they cannot be exponentially securitized. And because they cannot be exponentially securitized, their price cannot be sustainably manipulated.

Furthermore, if redeemability was affected, these markets would segment, into one with capped prices (where nobody sells), and an underground one, where inflation expectations inevitably will be shaped. In addition, their production is not the monopoly of any particular country and the rise in its prices, always ends in social conflict (as my uncle Alberto Mario once told me: “Every revolution begins with a baker being hanged by the mob”).

This will be a challenge, although not new. In the past, it has always been addressed with price controls, from the times of the grain trade between Egypt and Rome, to the 1930s with the creation of grain/meat Boards, which were monopolies that failed miserably at containing inflation. Canada and Argentina, for instance, are an example of the latter.  I have to give the intellectual credit to Albert Friedberg, founder of the Friedberg Mercantile Group, for bringing this challenge to light and remembering the Russian wheat deal of July-August 1972 (Mr. Friedberg’s quarterly conference calls are invaluable. This topic was discussed on January 31st here, after the 38^th minute)

There is no doubt in my mind that MMT will address with this challenge with repression too. In the process, food prices will rise but as I wrote before (here), this will not mean that Jim Rogers will be proved right. Farmers will not drive Lamborghinis. Prices will rise precisely because the opposite will occur and scarcity of production will be the norm.

-Overcoming the lack of a price system to allocate resources:

When prices are suppressed, markets cannot efficiently allocate resources. When this happens, defaults eventually follow. And as they take place and production falls, the difference between the former and actual output is seen as something negative. Of course, in a world with fiat currency and leverage, this gap is brutal. In a world without leverage, this would be mere evidence of creative destruction.

One of the most (if not the most) flawed concepts in non-Austrian economics is that of the existence of an output gap, which has to be closed by economic policy. The concept is so deeply embedded and so little challenged that it is assumed right away without further ado. It was in Martin Feldstein’s article (“When interest rates rise”) two weeks ago and it is in the famous Taylor’s policy rule.

The idea of an output gap denies the role played by the price system in allocating resources. In other words, it would be very wrong to think that because I could work until 10pm but leave my work regularly at 6pm, my output gap is 4 hours worth of my productivity. Why? Because I consciously decide to leave at 6pm, since I am not paid enough to stay at the office until 10pm. Vice versa, my employer does not see any marginal value that would be compelling enough to pay me for those additional hours. Therefore, even though the capacity/ infrastructure is there for me to stay at the office until 10pm, it is simply mistaken to infer that there is an output gap. It is even more idiotic to believe that by lowering interest rates, my employer would be willing to invest more, to fill that hypothetical gap.

There is one more angle to this. If there is a gap, it is understood that at some point in the past, I used to work until 10pm and now that I no longer do, it would be desirable that I go back to work until 10pm everyday. Why? Nobody wonders why I decided not to work until 10pm. Nobody asks why resources are no longer allocated to work from 6pm to 10pm. The reallocation of resources (of my time) is completely ignored. In the same fashion, when governments seek to close that gap manipulating the inter-temporal rate of exchange (i.e. interest rates), rather than facilitate a natural reallocation of resources, they insist with sustaining the old state of affairs, which was not desired, in the first place.

The idea of an output gap is Aristotelian in nature, and had Galileo been an economist in 2013, he would have invited Mr. Feldstein, Krugman or Bernanke to see for themselves that there has never been high inflation with full employment of resources; that high inflation is never triggered by an increase in demand, but by a lack of supply, when production collapses destroyed by fiscal and financial repression.  The scene of high inflation is a scene of empty shelves at supermarkets while goods are transacted at higher prices in underground markets; enforced high minimum wages under which nobody gets employed; banks that post negative lending interest rates but lend to no one (except their governments); entrepreneurs who borrow outside the system or vendor financing replacing working capital lines from banks.

With the steadily increasing level of financial repression, how will this challenge present itself to MMT? Via defaults. Until last week, I was convinced that these defaults would come first from the European Union. Now, I am inclined to accept the possibility that they originate in Japan. How will MMT deal with them? By creating more liquidity, of course. By further suppressing any possible signal.

-Suppressing a spiraling of inflation expectations in Japan:

The recent change in regime at the Bank of Japan merits a lot more than this final comment. When I have a moment, I will address it. Meanwhile, it is becoming clear to me that Japan is close to entering a Latin American-style spiraling cycle, where inflation expectations take the lead and the central bank can only follow.

As the Yen is devalued, capital in Yen-denominated fixed income and credit flees and is reallocated in the same, but USD denominated, asset classes. This simple movement increases interest rates in Yen, which is counterproductive to the initial efforts by the Bank of Japan. The Bank has to therefore purchase even more Yen-denominated debt, which triggers a further devaluation. As the devaluation makes imported commodities/food more expensive, the rate of devaluation channeled through to consumer prices can shape inflation expectations and the market may incorporate the expected rate of devaluation to Yen nominal yields.

Indexation is MMT’s worst nightmare. They were able to postpone it destroying the gold market, but this may prove a more formidable challenge. The unintended consequence of the Yen intervention is that the Bank of Japan ends up indirectly effecting quantitative easing on USD debt; both sovereign and private. This was in my view another bearish driver for gold, as the need for direct Fed intervention in the US Treasury market, on the margin, decreases.

As capital out of Japan floods the USD corporate debt market, credit spreads compress even further, weakening correlations among asset classes and making eventual defaults, of global consequence, more likely and dangerous. In summary, MMT is faced here with perhaps its biggest challenge, because the spiraling process just described sets the stage for an uncooperative Japanese central bank, which will be terribly busy trying to fix the unfixable. In Latin America, MMT often crystallizes in a controlled and segmented foreign exchange market. But this is unconceivable in a G-7 country like Japan and if any hint of it was even suggested, chaos of an unseen scale would fall upon the Asia Pacific region, dragging the rest of the world with it.

Conclusion

Last week, without any doubt, Modern Monetary Theory had a great victory. We are not in Kansas any more. From now on, without any price signals left, we will only be guided by volume, particularly in the labour market. This situation will persist until finally a new signal emerges. Whether it will come from the agricultural commodity market, the European Union or the Japanese fixed income market, remains to be seen.

Martin Sibileau

It is hard to make sense of the markets these days. For instance, gold showed no support while the geopolitical situation in Asia deteriorated, Japan embarked in the mother of all monetization programs, and a member nation of what is supposed to be a monetary union was imposed controls on the movement of capital. Or take the case of the Euro, which jumped from $1.2750 to $1.2950 on the day of one of the most confusing and embarrassing press conferences the president of its central bank ever gave.

However, in a faraway land, where there is no shadow banking, leverage or even capital markets, economic fundamentals still hold, which and can help us, inhabitants of the developed world, visualize a dynamics lost in the shelves of our collective memory. The land I am referring to is Argentina, but not Argentina of 2001. Today, I want to write about Argentina of 2013, and no, I will not discuss their legal battles with Mr. Singer.

Introduction

The topic I want to bring your attention to refers to an earlier article titled “What causes hyperinflations and why we have not seen one yet” (December 18^th, 2012). In it, I drew a few conclusions; the most relevant of which was that high inflation and high nominal interest rates are not incompatible, but on the contrary…they go together: There cannot be hyperinflation without high nominal interest rates. The article suggested that high interest rates are the product of a collapse in confidence, represented by a serious shrinkage of the deposit base in a currency jurisdiction. But the article was not exhaustive. It was limited to pointing out fear of confiscation, as the driver behind the collapse in confidence. This will be the driver behind the Euro zone break up. But there is another driver and Argentina of 2013 may be a template for the US. Bear with me…

Fear and greed

When human beings act/decide/choose, they face a risk/return trade off. When choosing whether or not to leave their savings deposited in a bank, indeed their decision can be driven by fears of confiscation. In other words, at a given return (almost 0% nominally and negative in real terms these days), if risk is perceived as too high, deposits will decrease or at best and at the margin, not increase. That was the scenario contemplated in my earlier article.

The most catastrophic example of the fear scenario is the monetary developments at the fall of the Roman Empire, when depositors took their monies and dug holes in the backyards of abbeys to hide them from either the tax man or barbarian hordes. However, the earliest documented example (by Isocrates; discussed by Prof. J. Huerta de Soto in his great book “Money, Bank Credit and Economic Cycles”) of this scenario dates back to 393BC and took place in Athens, triggered by the war with Sparta and the victory at Thebes, when Passio, an Athenian banker could no longer hide the insolvency of his bank (Demosthenes seems to indicate that Passio had a leverage ratio of approx. 5 to 1). He was not alone. A general run also against the banks of Timodemus, Sosynomus and Aristolochus ensued and it resulted in a deposit freeze that lasted 10 years (ref. Bogaert, Banques et banquiers dans les cités grecques). Those who feared first, feared best.

Fast forwarding some 2,406 years to 2013, what I missed in my earlier article (although it was implied in subsequent ones: i.e. on gold manipulation) is the “return” or greed component of the decision to shrink deposits. By this I mean that, for a given, known and manageable risk, if the return is perceived as too low, the deposit base can also shrink.

The perception of a low return will be shaped in relative terms. If there is an alternative to placing savings in a chequing account, for same or lower risk, the deposit base will shrink. In the developed world, courtesy of the creation of fiat gold and the volatility it generated around the price of the metal, such alternative is still non-existent. This was the smartest move of central bankers. But with the Cyprus event and others to come, without a Plan B, even this volatility can be ignored in favour of a longer term view on gold.

Argentina 2013

An example of falling deposits driven by greed rather than fear is Argentina in 2013. Depositors there learned the “fear lesson” already 12 years ago and for that reason, today a US dollar under the mattress is always worth more than a US dollar deposited in a bank. But the story didn’t stop there. Later on, as it became increasingly evident that the confiscation by the government had not ended with the default of 2002, the US dollar market saw another segmentation.  As the government competed with the public to source US dollars (to repay whatever was still left outstanding on their debt) and those dollars were out of the system, it decided to prohibit access to them in open markets. The repression began in earnest about a year and a half ago. For that “national and strategic” cause, even US dollar sniffing dogs were recruited to search for any US dollar bills, out of the system (watch here and here)

Since then, the market broke and there’s the official US dollar price, where of course you find no sellers, and the market price (for an unknown reason, called the “blue” market).  The graph below (source: Reuters/La Nación) does not need additional comments; it is self-explanatory. Today, while an official US dollar is worth about 5,15 pesos, the market demands about 8,50 pesos, or a 2/3rds premium.

So far, you will be asking yourselves how this can be a template for the US. And you would be right: The gold market is still one and the US government will never have to compete with the public to source physical gold to repay its debt, which is denominated in US dollars. But there’s more to it..

Why it can be a template

But let me get back to my initial point: Deposits can also fall driven by greed, rather than fear. In Argentina of 2013, deposits in pesos are now starting to contract exponentially, not driven by fear but by greed. Why? Argentines observe the escalation in the price of the US dollar bill outside the system (+25% YTD) vs. the interest paid on peso denominated deposits (-10% in real terms) or stocks (+18.5% nominally), and correctly figure out that they are better off with a king-size mattress than a bank account. Now, that to me is likely to be a template of what may happen in the US, once the market for fiat gold collapses. Here’s why: If the fiat gold market broke in a run for physical gold, the credit multiplier on paper gold would be crushed and from that moment onward  depositors in US dollars all over the world would see the performance of gold as a benchmark against US dollar deposits, just like Argentines today regard US dollar bills as a benchmark against their peso deposits. This is every central banker’s biggest nightmare: An asset whose price shapes inflation expectations.

The likely outcome of this would be an initial fall in USD deposits and a rise in interest rates, as the USD unsecured funding market would dry. Following this, the Fed, just like I am expecting the central bank of Argentina to do, would be dragged into a deficit (I am not going to explain here the mechanics of the deficit of a central bank. The reader may want to see my last article on hyperinflation, mentioned above).

As Argentina is at the gates of a new hyperinflationary process, it would be wise to follow it closely. It is a template. There are two conclusions that come to mind:

Conclusion No.1 : The Fed/US government would be better off not confiscating gold

Counter intuitively and contrary to the belief of the gold bug community, the US government would have every motive NOT to confiscate gold, for in so doing, they would trigger a run for physical gold and lose every leverage they have to suppress its price. This conclusion should hold even if a run for physical gold took place for other reasons. Their best move is to keep the suppression of the price of gold via fiat gold as long as possible.

Conclusion No. 2: The Fed would be more pressed than Argentina’s central bank to run a deficit

With the peso as a local currency, the pension funds nationalized, the absence of shadow banking and capital markets, if deposits in pesos drop, the central bank of Argentina does not worry about systemic contagion. As nobody there relies on the banking system to fund their businesses, the drop in deposits would likely end up affecting the profitability of the banks, with a high probability of seeing a complete nationalization of deposits.

The Fed however would be multiple times more pressed to intervene. Its liabilities affect credit and commodity markets worldwide, the pension and money market funds would be at the risk of collapsing. The high leverage of the shadow system would be too much. Therefore, the Fed would have to subsidize not just the US but the global banking system, to maintain US dollar deposits as a competitive alternative to gold worldwide. (Once more, to see how this would take place, please see this link)

Why I disagree with Martin Feldstein

Continuing with the topic of rising interest rate, in this recent article (link), Martin Feldstein expressed his concerns on the subject. Unfortunately, he does not explain how he sees that rise being triggered. He simply begins with “When interest rates rise…”. Unlike him, I have been explicit at least since December 2011: To me, the most likely driver is a wave of corporate defaults coming from the Euro zone, forcing the Fed to become the lender of last resort (in fact, they already are) and triggering a repudiation in US Treasuries. As a consequence, the repudiation of US Treasuries would further spark the fall of the money market and probably that of a commodity market clearinghouse.  In this context, the price of gold would not fall as Mr. Feldstein predicts.

In my scenario, before (i.e. independently of) the rise in rates,  credit spreads would rise as defaults increase. Markets would realize that the Fed is no longer in control and that the transfer of losses to the public sector are no longer bearable and the Fed would be forced to buy any US Treasury the market sells.

Martin Feldstein’s story has the opposite narrative thread. According to him, rates will rise and defaults will follow. In his words: “…Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities. When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall…”

How does Mr. Feldstein expect that rates to rise? Not because the Fed raises them, but because inflation expectations would drive nominal rates higher: “…If inflation turns out to be higher (a very likely outcome of the Fed’s recent policy), the interest rate on long-term bonds could be correspondingly higher…”

Mr. Feldstein omits to tell us what he thinks would cause inflation to be higher than the 2% targeted by the Fed, but my guess is that he has the mainstream economics model in his mind, whereby as the output gap decreases, prices increase. I will have more to say about such models in subsequent letters, but for today, let me end with this: There is no such a thing as an output gap. The notion of its existence is an ad-hoc mental tool, which dismisses the role of the price system in allocating resources.

Martin Sibileau

At the end of my last letter, I anticipated I would devote the next one to explain why, in my view, the European Central Bank is hypocritical on the Cyprus situation and why the rest of the periphery has to expect the same fate than Cyprus. Fortunately for me, Mr. Joeren Dijsselbloem who is both Dutch Finance Minister as well as the leader of the Eurogroup of Finance Ministers, confirmed my second point in a press conference 24 hours later, making my work easier…

A quick view of a bank’s capital structure

There are multiple issues on the Cyprus event. Perhaps the most relevant is the fact that unsecured depositors were sacrificed because their banks did not have enough subordinated debt to bail in. For this reason, the official story goes, Cyprus is a special case. Let me explain this point. In the figure below, I show the stylized version of the capital structure of a bank. From top to bottom, every portion of it is subordinated to the one immediately above it. It is clear that the least subordinated should be the deposits that finance a bank.

What is clear to us was not clear to leaders of the European Union. At closed doors, they first decided that deposits above EUR100M would arbitrarily lose 9% (in spite of existing subordinated debt to bail in) and put the matter to vote….only to revise this figure a week later up to 40% and without voting. It was hardly an ordinary bankruptcy proceeding; banks did not go through an ordinary liquidation and nobody could see an actual market appraisal of recovery values across the capital structure. The portion of such structure, which was supposed to be the most protected, saw its recovery value fluctuate between 9% and 40% within days because folks who live far away from this drama decided so over a weekend. On the other hand, those who held deposits of amounts below EUR100M are only entitled to them nominally. Effectively, they cannot withdraw their monies, let alone send them outside Cyprus. If they hold demand deposits believing that they can serve as medium of indirect exchange and they cannot use them precisely for that function, their property was affected, regardless of what the official story says.

Let’s return then to the thesis that Cyprus is a special case because the subordinated debt of its banks did not provide with enough cushion in the liquidation. As you can see from the figure above, the thicker the subordinated debt tranche is they lower the likelihood that unsecured senior debt and depositors will be affected. If Cyprus is a special case and it is not a template for the rest of the Euro zone banks, then it must be true that the rest of the Euro zone banks have stronger tranches below that of depositors. The sections below will show that during the last year (since March 2012):

a)   The same Euro zone authorities that imposed the loss on unsecured depositors were the ones who enabled a cash-out of subordinated debt holders, leaving depositors exposed to the firing squad,

b)   The Fed has been the ultimate enabler of this situation, and

c)    The fate of the US dollar is indirectly coupled with the fate of the Euro zone = There is no place to hide.

How the ECB financed the exit of subordinated debt holders

In December of 2011 and February 2012, the European Central Bank (ECB) extended longer-term refinancing operations to provide liquidity to euro zone banks. The liquidity, in euros and at a below market price, was against sovereign debt held by the banks, as collateral. Part of this liquidity was used for what is called “liability management” exercises, where the banks changed the composition of their liabilities: They borrowed from the ECB to repay their subordinated debt holders. This is the reason why Cyprus should actually be a template for the rest of the Euro zone. Because across the Euro zone, subordinated debt was reduced, leaving unsecured depositors exposed….again, across the Euro zone. The figure below, with the aggregate balance sheets of the main players, should help visualize what happened during the last twelve months:

In step 1, we see the focused balance sheet of the Euro zone banks and their subordinated investors (i.e. holders of subordinated debt), with regards to the subordinated debt. The same is a liability to the banks and an asset to the investors.

In step 2, we see the aggregate change caused by the extension of the LTRO Loans (i.e. loans issued under longer-term refinancing operations, by the ECB). These loans are an asset of the ECB and a liability to the banks.

Against these loans, the ECB issued Euros, which are an asset of the banks and a liability to the ECB.

In step 3, we see the transaction that I hold responsible for allowing unsecured depositors to be fair game across the Euro zone. With the Euros loaned by the ECB, banks bought out subordinated investors. Unfortunately, I have not had the time to quantify the exact impact of this transfer to date. However, reviewing past research notes released at that time (March 2012), my point will be clarified. (ADDENDUM: I HAVE BEEN GENEROUSLY FORWARDED TO THIS LINK, WHERE ZEROHEDGE.COM DID THE MATH ON THIS POINT, PROVIDING AN UPDATED STATUS ON THE ISSUE) 

On March 28^th, 2012, Barclays’ Credit Research team had published a report titled “European Banks: Liability management shrinks the bank capital market”. In it, it was estimated that at the end of March (only one month after the second LTRO), about 20% of the subordinated debt (equivalent to EUR97BN) had been targeted for exchange. The average exchange ratio of the transactions had been calculated at 82% of par (74% for Tier 1 and 89% for Lower Tier 2).  The reductions were split as follows: Close to 35% of cash out in the Tier 1 market (EUR54BN), 12% reduction of the Lower-Tier 2 (EUR37BN), and 18% reduction in Upper-Tier 2 (EUR6BN).

According to Barclays too, all the transactions had been bondholder-friendly, with an average 7pt (i.e. 7%) premium to secondary market across all issues (9pts for Tier 1, 5pts for Lower Tier 2). The main motivation behind all the transactions was capital optimization. They created capital gains to the banks. Except for two transactions in which the subordinated debt was exchanged for common stock or new Lower Tier 2, the rest were all tenders for cash. Greek banks in particular (i.e. National Bank of Greece, EFG Eurobank and Piraeus Bank) also participated in this liability management exercise; in some cases (i.e. Piraeus’s Prefs at 37 and LT2 floater at 50, announced on Mar 7/12) at premiums ranging 10 to 17pts.

In other words, both banks and subordinated debt holders enjoyed great capital gains, leaving unsecured depositors exposed to higher risk. This played out in the context of a virtuous cycle, where the cheaper funding improved the risk profile of the financial institutions and attracted capital back to the Euro zone. In the process, both the Euro appreciated and the EURUSD basis tightened, which further strengthened the equity of the financial system. The depositors of course, continued to receive mere basis points for their trust. On May 29^th and later on June 25^th, I had warned about the danger of this outcome.

But the story did not end here. In steps 4 and 5 of the figure above, I show the impact the Fed had in all this with its quantitative easing policy. By literally printing money in US Treasuries purchases, it added fuel to the fire, because Euro zone banks took advantage of the situation to borrow cheap US dollars, helping them repay their LTRO loans. Zerohedge.com has explained this with more detail than I can provide in this note, (in chronological order) here, here and here. I recommend that you read these articles in detail, if you want to understand how the game is going to end.

Step 6 seeks to show the status quo after the party. If the Cyprus situation is contained (which I doubt), going forward we should see the reduction in both assets (i.e. LTRO loans) and liabilities (i.e. Euros) at the balance sheet of the ECB and the banks, with banks replacing LTRO repaid loans with unsecured USD funding.

The Fed as the ultimate enabler tied the fate of the USD to the Euro

If you noticed, I circled the US Dollars held at the balance sheet of the Euro banks in step 6 of the figure above, as an asset. I did this because I want to emphasize a point I have been making for a long, long time: The collapse of the Yankee bond market (i.e. the market for bonds denominated in US dollars, where the borrowers are non-US resident corporations), caused by corporate defaults in the Euro zone will unmask the exposure that the Fed has to the fate of the Euro zone.  The dollars that end up with the Euro zone banks get recycled in multiple ways and one of them is via the Yankee market (another one is of course the USD loan market).

It should be clear therefore that this whole transfer of wealth will ultimately (and irresponsibly by the Fed) end up exponentially (through leverage) affecting those holding their savings in US dollars.

Final words

I am confident that the story above shows that far from being a unique situation, the fragile exposure of unsecured depositors across the Euro zone is the norm; and that their fragility was further increased in the last twelve months thanks to policies created by the same authorities who now refuse to honor their promise of a banking union, and instead impose capital controls, which have effectively destroyed any credibility on the safety of capital in the Euro zone.

One last word of caution: I think it would be wrong to interpret from the process depicted above that there was a premeditated conspiracy on the part of policy makers to weaken the position of depositors. This outcome, I believe, was simply an unintended consequence in their efforts to sustain the Euro zone. However, even if one accepts my view, the unintended outcome begs the following question: Why was there cheap money available for subordinated debt holders to cash out, but there is none now to protect the savings of depositors? Nobody can answer that question but with speculation, and as such, intellectual honesty demands that I keep mine to myself, because as Mark Antony said in Shakespeare’s “Julius Caesar”: “…You are not wood, you are not stones, but men; and being men, it will inflame you, it will make you mad”.

Martin Sibileau