Please, click here to read this article in pdf format:october-19-20101

Since our last letter, perhaps the most relevant event has been Mr. Bernanke’s speech, last Friday. Titled “Monetary policy objectives and tools in a low-inflation environment” (www.federalreserve.gov/newsevents/speech/bernanke20101015a.pdf ), this was a speech that made waves. Essentially, it made the case that given an environment with low inflation, there is room to look for alternative policy.  Will it be implemented as so many expect? The market’s belief that it will grows by the day. After yesterday’s release of capacity utilization (74.7% vs. consensus of 74.8%), the strength in the USD began to give way again…

As Mr. Bernanke put it, the topic of his speech was “…the formulation and conduct of monetary policy in a low-inflation environment…”. Interestingly, he introduced the subject reflecting on the fact that: “…From the late 1960s until a decade or so ago, bringing inflation under control was viewed as the greatest challenge facing central banks around the world…”. We wonder if Mr. Bernanke ever asked himself why it would be the case that since the Great Depression and until the late ‘60s the greatest challenge was to bring inflation under control. In fact, in the case of emerging markets, this challenge lasted well into the ‘90s and is the topic of the day again, as these markets seek to avoid the appreciation of their currencies by “printing” money to buy the US dollars Bernanke prints, thereby importing Ben’s inflation.

If Mr. Bernanke would have asked himself why central banks in the past decades had such challenges, he would have surely found out that it was because his predecessors, just like he today, thought that a little bit of inflation would do no harm, and that the pain of having a high unemployment rate was bigger than that of high inflation.

If Mr. Bernanke did not underestimate our intelligence, he would surely realize that we know that in the end, even that little or high inflation generated no employment. In fact, inflation generates unemployment. Here’s why:

Inflation destroys savings and produces a lower savings rate. This destruction also generates a shortage in the stock of capital, which deteriorates productivity. To be certain, productivity also declines driven by the uncertainty in relative prices generated by inflation. As productivity falls, it is less feasible to maintain a labour force at the existing level of wages. Therefore, entrepreneurs/firms can only survive if they can get access to lower “real” wages or to “cheap” credit, to finance their working capital (i.e. collections deteriorate as clients seek to delay payments to profit from inflation, and inventories rise because firms anticipate future higher input prices). Naturally, with inflation, credit disappears and governments find that the only way to keep the music going is by further debasing the wages of those employed.

This cycle spirals even faster in a global economy, because as a consequence of the fall in productivity and unemployment of resources, citizens of the affected nation must now import those goods that were previously profitably produced in their land. However, as their currency depreciates (“wins” the currency war) against the rest of the world, the cost of those imports rises, further cutting their ability to save. If the nation initially required an increase in the supply of money of $1trillion of US dollars per year (as it is speculated Quantitative Easing 2 will entail) to keep the original demand level for goods, as this cycle runs its course, the need for additional liquidity will increase to replace the reduction in savings, wealth, chasing an even smaller amount of goods produced. The need for additional liquidity grows linearly at the beginning and exponentially at the end. This why it is never “politically” feasible to return to a “normal” state.

Yes, Mr. Bernanke is right. Any central bank has the tools to fight inflation later on. But none, absolutely none, has the political power to assume the cost when inflation is evident and high. It takes radical political change to break the cycle, the likes of which Reagan and Thatcher brought in the ‘80s. We see nothing close to this on the horizon for the next couple of years coming from any country.

Martin Sibileau

Please, click here to read this article in pdf format: march-31-2010

This Monday, we attended a conference of The Economic Club of Canada, which had Mr. Paul Jenkins, Senior Deputy Governor of the Bank of Canada, as speaker. From the brief presentation titled “Beyond Recovery: Sustaining Economic Growth”,  we conclude the following:

-The Bank of Canada is most likely not going to explicitly intervene, if the Canadian dollar reaches parity and beyond. The speech itself was a message to Canada’s export sector to increase productivity to confront this appreciation.  The operative word here is “explicitly” because as we have written many times here, the Bank of Canada does actually intervene in the market via its repurchase agreement transactions.

-During the question period, we asked Mr. Jenkins about the Bank’s view on sovereign credit default swaps. We posed this question in a very open way, to test the reaction. Our impression was that Mr. Jenkins was not familiar with this asset class, as he referred us to upcoming G-20 meetings that will address regulatory matters related to the issue. We cannot blame him, since Canada has so far never been quoted in the sovereign credit default swaps market, given its relatively solid financial position.

-We are concerned about the view the Bank of Canada has on productivity, relative to the environment the country is in these days. We do not want to get too theoretical here, but we think the Bank of Canada still holds the nineteenth century view that value is based on the productivity of production factors. The Bank is lately making comments on the productivity of Canada, on the belief that if productivity increases to match the appreciation of the Canadian dollar, the country will remain “competitive” and avoid inflation.

Why are we concerned? Well, what is productivity anyway, and why do you think the Canadian dollar has appreciated?

I am sure most will agree with the opinion that the latest appreciation of the Canadian dollar, in light of the increasing sovereign risk concerns coming both from Europe and the US, was driven not only by the “commodity bid” that accompanied the recovery of 2009, but also by the “safe-haven bid”, which has left this currency almost neutral vs. gold. We first proposed this thesis back in June 2009 and refreshed it on March 4th (refer: “Meanwhile in Canada”, in: www.sibileau.com/martin/2009/06/02 and “The stars favor Canada”, in: www.sibileau.com/martin/2010/03/04 ).

If we are correct, Canada is not only competitive supplying the world with commodities, but with financial, fiduciary services too. The main fiduciary service is ironically supplied by the Bank of Canada (which means its staff is grossly underpaid) that seems to be very competitive providing a reserve asset to the world. In fact, perhaps this country is way more productive exporting a reserve asset than oil or gas or mining products or engineering services. But would this productivity be included in the Bank of Canada’s calculations? Why not? Why should we worry if we are not more competitive than Brazil destroying our forests to win the forest products market? Why should we be concerned if we are not effective contaminating our boreal landscape with oil sands projects so that we may compete with the Saudis in the energy sector? What is wrong with being competitive with fiduciary services? The Bank of Canada of course doesn’t share our perspective and will never clarify that they implicitly make a subjective judgment on productivity.

Lastly, for those interested in the formal aspect of this discussion, we refer to the concept of a “Social welfare function”, under the Theory of Public Choice. In our opinion, for the Bank of Canada, this function is:

W = y1 + y2 + …+yn ,

where W is social welfare and Yi is the income of a sector i among n in the Canadian society. To maximize the social welfare function we may seek to maximize for instance the income of sector 1 at the expense of sector 2, if we deem sector 1 is “more productive” than sector 2. Does it make sense to you? In our view, the function (and by the way, we don’t think there is such a thing as a social welfare function) should be: W = y1 =y2 =…=yn. But this is a discussion for another time!

Martin Sibileau

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.