Yesterday was another forgettable session. News of the pig flu, of the Federal Deposit Insurance Corp. Chairman Sheila Bair seeking authority to close “systemically important” financial firms, and of GM’s bondholders’ rejection of the $27BN debt-for-equity swap shaped a tense range trading day. The S&P500 closed -1% at 857.51pts. Treasuries had significantly dropped by noon, but managed to close up in a flight-to-safety move, driven by fears of a pig flu spreading. This same flu pushed Mexico’s credit default from 300bps to approx. 330bps. The Fed bought $7 billion in Sep/13 to Feb/16 Treasuries. Agency debt continued to tighten vs. Treasuries (1 to 2bps) and CDX IG12 finished flat, at 176bps. And we should leave things here.
While we wait for more policy decisions (FOMC meeting today and tomorrow, Fed purchase of Treasury coupons on Thursday), I thought it would be interesting to reflect not on the origins of this crisis, but on the origins of the ideas that shaped the response to this crisis. Most of you would agree that Mr. Keynes’ ideas are behind the policies being implemented these days. Therefore, let’s analyze Keynes’ thoughts on what to expect from a financial crisis.
John M. Keynes’s main work was the “General Theory of Employment, Interest and Money”, published in 1936. Today, we only need to deal with chapter 13. This chapter is titled “The General Theory of the Rate of Interest”.
Keynes was a very practical man. For him: “…the rate of interest is…the “price” which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash…” If we follow him, at close of yesterday, the benchmark (Feb/39 Treasury) price for holding USD cash long term was 3.84% p.a.
Keynes warned that: “…circumstances can develop in which even a large increase in the quantity of money may exert a comparatively small influence on the rate of interest…” Yes, this applies to the $300BN Treasury purchase program by the Fed. I let the reader judge the degree of influence this program has had so far (1 month later) on the rate of interest.
Keynes offered an explanation for these circumstances. He wrote that: “whilst an increase in the quantity of money may be expected… 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” This should be self-explanatory and consistent with the necessary conclusion from our Thesis no.1 “Sell that which the US Govt. is buying and buy that which the US Govt. will buy (Tincho’s letter, April 6th 2009)”. Keynes further added that: “…whilst a decline in the rate of interest may be expected … 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…” What is the “marginal efficiency of capital”? Basically, it is the (IRR) internal rate of return (refer Chapter 11 of the General Theory). Given a rate of discount, the IRR of a stock is driven by its dividends and final value. Since the beginning of the current crisis, dividends have been continuously cut or eliminated altogether, while stock prices have been falling. It is obvious then that the marginal efficiency of capital was falling until the current rally took place, in late February 2009. Is the marginal efficiency of capital STILL falling more rapidly than the rate of interest? I am not sure, because: a) we still ignore what level of losses the financial system may face in the future b) this ignorance means that we also have uncertainty on how expensive it will be to finance future investments c) given (a) and (b), we don’t know what the final inflation level will be, as the Fed continues to pump liquidity into a broken system. (On September 18, 2008, Goldman Sachs’ US Portfolio Strategy team published an analysis in line with Keynes’ approach. The publication suggested that the implied S&P500 trough for this crisis was at 1,000 points, consistent with a dividend yield of 2.9% for the S&P500 index).
Keynes continued his exposition saying that: “…whilst an increase in the volume of investment may be expected … to increase employment, this may not happen if the propensity to consume is falling off…” If I am right and the Obama administration is guided by these Keynesian ideas, we should therefore expect further policy from the Fed and the Treasury to address the retail credit market and the personal income tax structure, respectively, to boost consumption.
Finally, Keynes says something rather ominous: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…”. Essentially, the final rise in prices that we may expect will depend on how we address productivity issues today (i.e. physical supply functions…Will we keep wasting money on the auto sector?) and how our current politicians reshape the labour market today (i.e. contract negotiations with unions, etc. that determine the liability of the wage-unit to rise in terms of money).
The final sentence is perhaps the most relevant. Keynes wrote that “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…”. THIS STRONGLY SUGGESTS THAT AN EXIT STRATEGY BY THE FED MAY BE COUNTERPRODUCTIVE. INFLATION MAY HIGH ENOUGH FOR US TO NEED TODAY’S INCREASE IN THE QUANTITY OF MONEY TO MAINTAIN THE RATE OF INTEREST AT THE END OF THIS EXPERIMENT.