Getting to the Source of Systemic Risk

Recent articles on the US and world economic crisis have often been focused on the concept of ‘systemic risk’. For example, Robert Pozen, author of Too Big to Save?, argues in The Wall Street Journal (7/9/09) that the Federal Reserve ought to be given the job of monitoring systemic risk. What this refers to is certain kinds of financial ‘products’ and practices that have often graced the headlines of late: credit default swaps, collateralized debt obligations, and other kinds of credit derivatives.

The idea that the financial crisis has been caused by exotic new financial instruments—from credit derivatives to adjustable rate mortgages—has become part of the conventional wisdom. But is it true?

No doubt there is always a tendency to find fault in new practices that seem to be responsible for disasters, such as humbling the titans of finance with billions of dollars of losses, charmingly called ‘write-downs’. But how does that lead to systemic risk? If a large corporation (financial or otherwise) loses billions or even hundreds of billions, how does that threaten the system as a whole? Well, corporations often owe money to other corporations, and perhaps if a large lender goes under, other firms are placed at risk. That does indeed sound bad. But how is it different from the usual course of events? Companies rise and fall. Taking risks can lead to success or failure. When an idea leads to a failure, that strategy tends to be repeated less than those that are successful. A failure, even a large one, poses no threat to the system. Failures are an integral part of the system. Even the largest corporations are subject to market forces. And thank goodness for that. Big corporations must be exquisitely sensitive to quality and reputation, or else they are at risk of losing market share and potential takeover.

In the same way that nature rewards certain kinds of risks and penalizes others—successful strategies lead to greater propagation of a species—an evolutionary market-based process is the best enforcer of risk. The Fed or any regulator will always be 10 steps behind. Even if the government regulator happens to be on time, what should the penalty be? Will such penalties be subject to political forces—such as those that determined that Lehman should fail while Bear Stearns or AIG is rescued?

The nature of markets is the equalization of risk and return. Risky activities ought to have high returns, while less risky activities yield lower returns. Financial markets are filled with risky products that are hundreds of years old. Short-selling (the practice of borrowing shares in order to buy them back later, hopefully at a lower price) exposes the seller to potentially unlimited risk. Out of-the-money options that are close to expiration are also extremely risky. But these options are priced accordingly, not by government regulators, but by the market.

Yet even when markets are functioning well, it’s true there is a systemic risk lurking. At any moment, banks could collapse, for their reserves are only a tiny fraction of their deposits. Any threat to the banking sector sets off a damaging spiral: bank failure leads to bank runs, leading to loss of faith in banks, leading to further contraction in lending and paralyzing the conduit that runs from savings to investment.

This is why economists Kotlikoff and Leamer argue for a new financial architecture, one that does away with this source of systemic risk once and for all, while channelling society’s savings into investment, and providing prices for financial assets that correctly equalize risk and return. (See “A Banking System We Can Trust”, Forbes, 4/23/09). Their brilliant proposal would essentially to do away with the fractional reserve system. Unfortunately, this proposal has received little attention or discussion in the US. I get the sense we’re sick of the topic here. We’d rather believe in the green shoots that are supposedly sprouting. They say ‘less bad’ is the new ‘good’. My guess is that as the rally fades and new risks to the system are revealed, there will be an surge of interest in reforming the fractional reserve banking system, the source of systemic risk to the economy.

Gold Correction

Gold is one of the few assets in the world which is in a primary bull market, meaning that the asset is rising overall, despite periods of downward movement. We're in one such period now, which is going to act as a brake on all gold-related assets, including mining stocks like Seabridge Gold SA which I've recommended.

I still think the stock is a long term win, but I must say that it's likely it will go into correction mode (in fact, it already has fallen $6 or so from its recent peak, a 20% decline). Those with a short-term frame may think about selling, even at a loss, in order to get back at a lower price.

Since I expect the overall market to begin another period of decline, I like a stock that will move inversely to the market, like DXD. (Remember, DXD is for short-term trading only; it has mathematical characteristics that make it a poor long-term investment.)

I suppose I now have to break my 10 grand bit into two groups: long term and short term. Long term, stay with Seabridge, even though you're down right now. It'll come back. Short term, take the loss and move into DXD while you wait for SA to bottom out.

Cheap Gas

Detroit!

Stop tempting us with your cool new muscle cars, like the new Camaro, which gets 22 mpg (on a completely flat road, driving the speed limit, which I'm sure I will be with a 304 horsepower engine).

What with the fall in gas prices and all, the Camaro is destroying the Honda Insight in the sales department.

I guess the thinking behind the muscle car resurgence is, wouldn't it be nice to go back to a simpler time, when all that mattered was how many horses you had under the hood?

It just doesn't seem like the best move, to stake the fate of the American car industry on denial.

Deflation

The Bureau of Labor Statistics released the Consumer Price Index yesterday, which shows a very small monthly increase since April (0.1%), but the story that's grabbing the headlines is the 12-month drop in prices, or deflation, to the tune of negative 1.3%.

It's a bait and switch story. What number do we emphasize? The scary number, about the deflationary monster? Or perhaps the core inflation number, which excludes food and energy, and shows a 12-month increase of 1.8%? Only two categories in the CPI fell: transportation and energy. Both are tied to the fall in oil and gas prices. Every other category increased.

What does this tell us?

Expect inflation, not deflation to prevail in the coming months.

Ah, Krugman!

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

The above is a quote from the marvelous Paul Krugman. I love him; and yet, he's so wrong right now.

Let's be clear: aggressive monetary and fiscal policy have not averted any danger to the economy. The danger is not inflation, nor is it deflation. The danger is economic distortions. That is, massive investment in unproductive economic activity (retail, advertising, finance, etc.). This kind of economic activity does not produce anything, and hence it is the major threat to the economy.

Why are there economic distortions? Why should it be the case that the market, which often gets things right, ought to be disastrously wrong? What causes the distortions is the massive inflation of the money supply. That may lead to inflation or it may even lead to stable prices, even deflation for a time. It all depends on how the extra dollars are used. If they are saved, no inflation in consumer prices. If dollars are spent elsewhere in the world, no inflation (at least in the US). If those extra dollars are spent in the US, expect to see some inflation.

Rising or falling prices is not the danger. The danger is that there is a prolonged period of confusion: what are my assets worth? Is my business viable? Should I start this business? What is the market saying?

If the answers to these questions are unusually obscure for a long period of time, the result will be stagnation, low growth, and unemployment. This is the danger. And it's in full bloom now. More aggressive monetary and fiscal policy will worsen the situation, not make it better.

Stocks Fall

The Dow has, as of this moment, taken a big hit. It feels like the rally is over.

I expect that there may be an upward movement tomorrow, but I think the rally is basically out of steam.

Seabridge took a big hit today, falling to $25. I expect it will go up to $29, but then follow the market down. I think gold may have a big day tomorrow, as a new wave of fear washes investors out of stocks and into the safety of gold.

I'm going to try to sell SA at or around $29, and get into DXD at or around $45.

Arthur Laffer on Inflation

Arthur Laffer created the Laffer Curve, a rather dubious piece of economic theory that entered the economic canon without ever passing through the peer-review cycle.

He has a rather good piece on inflation and monetary expansion in the Opinion section of the Wall Street Journal.

His argument is that the monetary base has increased dramatically, and that this should result in inflation. Since I've been saying the same for some time, I like the argument.

As Gold Continues to Slide, Treasuries Crater, World Openly Debates the Fate of the Dollar

{I wrote this on 6/8, but didn't get around to publishing it until 6/11, which was after the WSJ wrote a cover story on the rising 10-year Treasury!]

The yield on the 10-year US Treasury note is up to 3.88%, [now it's gone up to 3.93%, then slid back to 3.86% today] as prices for the note continue to crater. (Recall that as bond prices fall, yields rise) The battle continues. Since this yield is tied to so many other interest rates, the hazard is that the rising yield will soon become higher interest rates for mortgages, car loans, credit cards, etc. The bigger problem perhaps is, are there borrowers?

It's an economic distortion that interest rates should fall when the economy moves into recession and credit tightens after being loose for so long. What's being revealed is that the risk of default is much, much higher than was previously thought. Naturally, interest rates should rise to compensate for the increased risk. But instead, the Fed tries to go against the market and lower interest rates.

The Keynesian logic is straightforward: because credit is tending to tighten, money destruction ensues through the action of the fractional reserve banking system. However, that destruction of money results in far less aggregate demand. The solution: create money through the central bank (the Fed) equal or greater to the money destruction, lowering interest rates, encouraging firms and consumers to borrow, and stimulating the economy when it most needs it.

Unfortunately, what this Keynesian story overlooks is that the economy has a hangover. The best cure isn't a couple of (trillion) shots of booze, it's a reorganization, a re-thinking of priorities and activities.

The economy has binged on unproductive economic activity: a frenzy of finance, retail, advertising, lawyering and lawmaking. Corporations have turned their attention away from productive investment (the kind that is designed to produce better things) and toward unproductive investment, designed to capture an ever-larger piece of the economic surplus. But since efforts to capture a bigger piece of pie don't actually grow the pie, only so much of US capitalism can be engaged in such endeavors.

Meanwhile, the International Monetary Fund, seeking to retain some kind of relevance, jumps in to say that the world could potentially use a different reserve currency than the US dollar. Of course, their solution is the bogus Standard Drawing Right, administered by an impartial, international central banking organization. I wonder who that would be. Of course, they call for "liquidity", a silly central banking code word which means "fake money". It's obvious that the IMF does not have in mind the creation of a currency backed by an item of real tangible value, such as gold. After all, Keynes called gold a "barbarous relic".

Of course the IMF thinks we're years away from such a "revolutionary" move. Only slowly can we change the global monetary order.

Right.

The world has a way of changing faster than you think. The dollar is already dead. Each country in the world is simply trying to figure out how to edge away from the dollar's corpse before every other country in the world does so. Gold has tripled in price since the year 2000. The technology of producing gold hasn't changed much.

The world faces a choice: either we descend into a morass of distrust, reversing the tide of globalization, retreating behind border walls and tariffs, or we create a new global monetary order that no country, no individual, no corporation can game. That order simply must be based on an item of real value, that no government can manipulate, that holds its value over time, that cannot be destroyed through the printing press. We need the gold standard of money. What could that be?

I'll Be Off For the Rest of the Week

Treasuries are up today, pushing the yield back down to 3.55%. Still too high. With the ten year US Treasury note at that yield, a lot of other interest rates are going to be higher. Still a lot of volatility in this market; today's swing was 2.55%. A lot of movement for any market in one day.

How can the Fed possibly re-inflate this impossibly flaccid credit bubble with high rates?

Commodities took a pause; gold is back under $970, oil retrenched to $66, copper's down to $2.22. A bit of backfilling is in order. I wonder when the next big move up will happen. Next week?

Meanwhile, banks are doing their best to resist honesty and transparency. Here's a piece about their off-balance sheet assets. Isn't it a bit absurd that a corporation would have off-balance sheet assets? What possible rationale could there be for keeping an asset off the books besides lying about its true value?

I'll be traveling for the rest of the week. Have a great weekend!

Ferguson vs Krugman

Historian Niall Ferguson takes Paul Krugman to task in a recent Financial Times piece.

Ferguson is right of course, that the debt load of the US is onerous and that our creditors are starting to wonder if we'll ever pay it back.

While Ferguson is correct that we have not entered a repeat of the Great Depression yet, I think he lays a bit too much emphasis on that fact. Yes, we're not there. Yet. The big difference, of course, is the status of the dollar as the world's reserve currency. That will change, and as it does, a series of painful adjustments will take place in the US.

GM Bankruptcy...

(The picture is of Alfred P. Sloan, the man who created GM as a consolidation of several smaller automakers)

I feel I have to say something about the GM bankruptcy, simply because the story is dominating the news: WSJ, NY Times, USA Today.

Frankly, the story bores me. It's full of wailing and gnashing of teeth, sound and fury, signifying nothing.

Why should I care that GM is going bankrupt? Is it simply because it's a venerable corporation? That doesn't do it for me. A corporation (or any institution) doesn't deserve to continue just because its been around for a while.

In an earlier era, the economist Joseph Schumpeter called capitalism "creative destruction". Like living organisms, corporations are born, they flourish, they fail, they die. When they fail or die, the corporate body (redundant, I know, because both words mean the same thing) becomes food for other economic agents: other corporations, individuals, institutions.

It is only our tendency to cling to the past that makes us think it is somehow wrong that a big corporation should go bankrupt. It's not wrong, merely part of the artificial garden of capitalism. People say, what about the workers? What about the jobs that will be lost?

It's better to clear out an institution that is not functioning, so that new jobs can be created. Americans will still buy cars. So other producers will buy GM's plants and equipment, hiring some of the workers, while others will find new jobs doing other things.

Change is hard. Some people may have to leave the communities they know to find work elsewhere, or they may need to start new businesses, or accumulate new skills. But this change is the cornerstone of the economy. To resist it, to go against it, to prop up these companies and others like GM that made disastrous errors during the boom years, is wasteful, inefficient, and rewards incompetence instead of productivity.

Treasuries Crumple... Again!

Crash... recover... crash.

The price of the bellwether 10-year US Treasury note cratered Thursday, recovered Friday, and now has crumpled again, sending the yield skyrocketing to close at 3.715%.

This is exciting stuff. It's like a pitched battle is being waged over Treasury notes. The yield is like the front line. Meanwhile, the kings of the commodities (oil, copper, gold, silver) are all up sharply. Oil is above $68, gold is above $975, silver is above $15.60 and copper has shot up to $2.30. (Check out NYMEX for a good source on all these commodity prices.)

Remember, this may be a harbinger of higher interest rates, signaling a loss of confidence in the dollar, which would mean the Fed would have a very hard time using monetary policy to stimulate the economy.

What will happen is that interest rates will rise as investors edge away from the dollar and US treasury debt. That will deepen the recession. (Why do I say recession instead of depression? Habit, I guess. There is no technical distinction in economics. There is a joke (sort of): a recession is when your neighbor loses his job. A depression is when you lose yours.) The best strategy for dollar depreciation is investing in hard assets with no debt or leverage whatsoever.

Geneen Roth Interview

Geneen Roth, author of When Food Is Love (and many other books), and a friend of the family, has a podcast of interview she gave after losing nearly everything to the Bernie Madoff fraud. She also has a nice piece in the Huffington Post on the same topic.

It's very touching to me how mature, responsible, yet real are her reactions to losing so much money. The same goes for my mom and my stepdad, my stepmom, and so many of the people I know who lost all or nearly all.

A Funny Madoff Video

This video is by a family friend, Matt Weinstein, who, together with his wife Geneen Roth, is part of the circle of family friends that includes my family that invested with Madoff and lost everything. (I wrote about it in an earlier post)

Now Treasuries Recover!

This is getting exciting.

After a massive sell-off that sent the yield on the bellwether 10-year Treasury note skyrocketing to an intraday high of 3.75%, investors snapped up the debt Friday, sending the yield back down to close at 3.465%. That is one wild ride.

Remember that the Fed would like to see the yield below 3%. A rapid increase in the yield is the market's way of rejecting the Fed's monetary stimulus.

It's interesting that the market had such a rapid snap-back. No doubt some investors were seeking bargains. Was one of those investors the Fed?

The dollar is coming apart. Was this a warning shot or the beginning of the final conflict?

Stay tuned...

Krugman: Don't Worry About Inflation

Paul Krugman is at it again. (Here's a picture of him with former President Bush) 

This time, he reassures us of two ideas: 1) all that money the Fed is creating won't push up prices, and 2) the US would never default on its debt obligations by inflating away the debt.

So, for Krugman's first assertion, while he is correct that the contraction in bank lending has counteracted the increase in money created by the Fed, it flies in the face of logic to think that the Fed can create trillions of dollars out of nothing and that this will have zero effect on prices. Doesn't it seem more likely that certain prices are being prevented from falling to their equilibrium level by the Fed's monetary mischief, thus distorting the price mechanism? 

See, the thing is, the US is approaching this psychological level, where the debt of the Federal government approaches 100% of GDP. This is only important because people often fail to see that the two can't be compared directly - GDP is a flow, like your yearly income, and debt is a stock, like the value of your stock portfolio (except in reverse!). So just as a person who makes $50,000 a year could owe $75,000, so it is possible that the US debt exceeds GDP, and nothing really changes from debt being 90% of GDP to debt being 100% or more. However, GDP is a good reference point for understanding the level of debt, because it shows our capability for paying back the debt, and also gives us a yardstick which adjusts for changes in the price level and economic growth.

Now there's this thing called denial. When a lot of people say "you don't need to worry about that," they're often saying, "I get why you're worried about that - you should be". Krugman's denial of inflation is similar to his denial of debt default. There's no way the US would default on its debt, he shouts. No way in hell! 

In other words, it's extremely likely. All signs point toward default: escalation in borrowing, continued current account deficits, falling dollar, rising yields.

Paul Krugman, I salute you. You're a great economist. You've made important contributions to the theory of international trade. You were right about the war in Iraq. But you're wrong on this: the US will default on its debt, and the method we'll choose is inflation. I'd suppose you have 5 or 10 years before you have to admit your mistake. 

I'll be waiting!

The Rise of Oil and Gold Is An Early Sign of Inflation

(This filthy-looking pool of oil is from the Exxon Valdez oil spill)

The Federal Reserve must be happy now; they're doing their job: fighting deflation by creating money out of thin air.

The oil price is over $65 now, and gold is over $978. This is an early sign of inflation. We're in an odd situation economically; certain items are in deflationary mode. Deals are

everywhere on housing, furniture, cars, appliances, clothing, travel. These are items that consumers are cutting back on.

Since oil and gold are investment commodities, they are seeing appreciation now because of fears of inflation and the desire to protect assets. A good way to get exposure to the oil price easily is through the oil ETF USO. (This is good for long-term exposure; USO doesn't always track short-term movements in oil prices accurately, because it is the target of arbitrage)

What about the ethics of investing in oil? My dad won't touch it; he says it's a dirty business. Similar concerns have been raised about gold, which is produced by crushing tons of rock into a fine powder, then using acid to dissolve the metal, a process that uses copious amounts of energy.

Each person's ethics come from within. For me, I don't rule out profits from oil or gold, because it doesn't seem helpful to me to say I won't invest in something but I will use other products. I own a car, I own electronics, I have gold in my teeth. If I touch it as a consumer, I'll touch it as an investor, where at least there is an opportunity to make a profit. These things have to be decided on a case-by-case basis. Every corporation is guilty of something, as is every individual.

As Treasuries Swoon and the Dollar Falls, Gold Advances

Gold has been on a tear the last few days, taking back its role as the bomb shelter of financial assets. During the tail end of the boom years (2006-2008) gold began to move in tandem with stocks. The market would be up, and so would gold. That was unusual.

Now gold is back to moving inversely to markets. As I wrote yesterday, US Treasuries are falling, causing yields to rise. (Check out ^TNX) As I write this, the market is experiencing a bounce as it absorbs the activity of the last few days. The dollar is also falling, and has breached the psychologically important 80 level.

Seabridge Gold (SA) is now up to $30.66. If you bought Seabridge Gold back when I said, your money would've grown to $11,927 by now. I see SA going to $40, so hold on to what you've got. I also own Exeter Resource Corp (XRA). Exeter is a small-cap gold mining company from Canada, which is home to many such mining companies. Many of these are unsound, and will get shaken down by the movements of the gold price, but Exeter is one that will remain, I think, as they have very low levels of debt and they seem to have a solid business plan.

It's a good idea to have some GLD, the exchange traded fund that holds gold bullion, as well as some SLV, and some physical gold and silver in your possession. Another good way to invest in gold is through Goldmoney.com.

Treasuries Crumple!

The price of the bellwether 10-year US Treasury note cratered yesterday, sending the yield skyrocketing.

This chart (^TNX) shows the yield of the 10 year US Treasury note. (As the price of a bond falls, the yield rises)

Look at the pattern of the last few days. The yield is up rather sharply. Keep in mind that this 10 year Treasury yield drives a lot of other interest rates, including mortgages. People often think that it's the Fed that controls interest rates. Not really. The Fed influences interest rates, and has been struggling to influence the yield on the 10 year US Treasury note, but the Fed is only one player in a big and very complex game. Sure, the Fed is one of the few players that can (semi) credibly print money at will, which is what they do when they want to push the 10 year Treasury yield down. They print money, then spend it buying Treasuries, which pushes prices up and yields down.

The Fed is losing a massive, behind-the-scenes battle. The Fed must keep this yield under control. But it must do it quietly. If investors get to thinking the Fed is the only buyer of Treasuries, they will sell, sending the price down even further. Also, it looks as though foreign central banks, which hold a lot of US Treasury debt, are starting to quietly edge toward the exit, and see the Fed's buying sprees as a good opportunity to sell off some of their holdings. The more money the Fed creates to manipulate markets, the more precarious becomes the state of the dollar, because it becomes more and more obvious that the plan is to inflate away the debt.

About the size of this market: check out the Treasury direct website. The total US Federal government debt is about $11.3 trillion. The US stock market, by comparison, is about $9.3 tril, as measured by the Wilshire 5000.

If money really begins to flee the US Treasury market, where will it go? Keep in mind that when someone sells a US Treasury note, they are paid in dollars. If the idea is to avoid the depreciation of the dollar, then the money must go into another currency or asset that is outside the ability of the Fed to depreciate. The obvious candidate is gold, but I expect we'll see continued movement into the Euro (note that the Euro is up strongly against the dollar recently, which tells us that many investors don't buy the rally. If the worst was over, why would the dollar be falling against the Euro?)

Interview with Robert Prechter

Here's a video from Feb 2008 with legendary investment advisor Robert Prechter, author of Conquer the Crash and founder of Elliot Wave International. His company uses a variety of data, but his training is in psychology, and you see the influence. He looks a great deal at how people feel on an unconscious level; he calls the approach Socionomics.

Barron's has a nice interview with Prechter in which he argues that we're entering a long-term recession with deflationary tendencies. He sees further declines in the stock market, based on the fact that P/E ratios have not fallen enough to mark a bottom. Optimism is also high.

I agree with his analysis in general, though I think the Fed will win the battle against deflation by creating trillions of dollars of new money, as they have been. So far the Fed has avoided all but a slight amount of deflation. Prices over the last year have been flat overall, despite large decreases in the price of housing.