Wednesday, June 24, 2009

Recommended reading and chart of the day

Via:  Business Week  Chart of the day.  And the jobs that have been created have been in the EdHealthGov sector mostly.


Via:  Jesse  The Weimar hyperinflation was accompanied by high unemployment and massive debt issuance.

Some common fallacies about inflation and deflation:  the Weimar experience

There are several fallacies making the rounds of the economic community, often put forward by pundits on the infomercials for corporate America, and also on the internet among well-meaning but badly informed bloggers.
The first of these monetary fallacies is that 'the output gap will prevent inflation.' The second is that a lack of net bank lending or other 'debt destruction' will require a deflationary outcome. Let's deal with the output gap theory first.
Output gap is the economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity.
The theory is that when GDP underperforms its potential, with unemployment remaining high, there can be no inflation because demand is weak and median wages will be presumably stagnant. This idea comes from neoliberal monetarist economics, and a misunderstanding of the inflationary experience of the 1970s.
The thought is that sustained inflation is due to a 'wage-price' spiral. Higher wages amongst workers cause prices to rise, prompting workers to demand higher wages, thereby fueling inflation. If workers do not have the ability to demand higher wages there can be no inflation.
While this is in part true, it tends to confuse cause and effect.

The cause of a monetary inflation, which is a broadly based inflation across most products and services relatively independent of demand, is often based in a monetary expansion of the currency resulting in a debasement and devaluation.

A monetary expansion is relatively difficult to achieve under an external standard since it must be overt and often deliberative. A gradual inflation is an almost natural outcome under a fiat currency regime because policy-makers can almost never resist the temptation of cheap growth and the personal enrichment that comes with it.
There can be short term non-monetary inflation-deflation cycles that tend to be more product specific in a market that is not under government price controls. But this is not the same as a broad monetary inflation or deflation.

The key difference is the value of the dollar which has little or nothing to do with a business cycle or product demand/supply induced inflation/deflation.
In the modern era the Federal Reserve can increase the money supply independent of demand by the monetization of debt, with the only restrictions on their ability to increase supply being the value of the dollar and the acceptability of US sovereign debt. This requires the acquiescence of the Treasury and the cooperation of at least one major money center bank.
People tend to invent 'rules' about how the money supply is able to increase, and confuse financial wagers and credit with money. This is in part because the average mind rebels at the reality behind modern currency and the ease at which it can be created. Further, people often invent facts to support theories that they embrace in an a priori manner.
In a pure fiat currency regime, the swings between inflation and deflation are almost always the result of policy decisions, with the occasional exogenous shock. A government decides to inflate or strengthen their money supply relative to productivity as a policy decision regarding spending, central bank credit expansions, banking requirements and regulations, among other things.
As a prime example of a rapid inflation despite a severe economic slump, what one might call uber-stagflation, is the Weimar experience.
Since pictures are worth 1000 words, let me be brief by showing you a few important charts.

The basic ingredients of the Weimar experience are...

A high level of official debt issuance relative to economic growth

High unemployment with a slumping real GDP

Wage Stagnation

I should stop here and note that although the statistics at hand involve union workers, in fact unemployment was widespread in the Weimar economy. The saving grace of being in the union was that one was more often able to retain their jobs and some level of nominal wage increases.

Anyone who has read the history of the times knows that unemployment, underemployment and slack demand was rampant, and that hoarding was commonplace as people refused to trade real goods for a rapidly devaluing currency.
Rapidly Rising Prices Despite Slack Demand and High Unemployment

So much for the wage price spiral and the output gap.
A Booming Stock Market, at Least in Nominal Terms

Booming Price of Precious Metals as a Safe Haven Even While Basic Material Prices Slumped

Notice the plunge in the price of copper as the economy collapsed and gold and silver soared.

If one can obtain a copy, as it is out of print, one of the best descriptions of the German inflation experience is When Money Dies: the Nightmare of the Weimar Collapse by Adam Fergusson. There is a copy of the book available online for free here.
From my own readings in this area, the people who tended to survive the Weimar stagflation the best were those who:
1. Owned independent supplies of essentials including food and shelter and were reasonably self-sufficient.
2. Had savings in foreign currencies that were backed by gold such as the US dollar and the Swiss Franc
3. Possessed precious metals
4. Belonged to a trade union and/or had essential skills or government position which guaranteed a wage
5. Were invested in foreign equity markets, and even in the domestic German stock market for a time

People will argue now that the Fed understands that inflation is caused by perceptions, and that by managing those perceptions inflation can be avoided because even those prices are rising and the currency is being devalued, if they ignore it the inflation cannot reach harmful levels.
This is what I call the "psychosis school" of behavioral economics.
Granted, perception is important, and managing perception may delay outcomes for a period of time. But unless the underlying cause of the problem is remedied during what is at best is an extended interlude, the resulting break in perception will ignite a firestorm of cognitive dissonance, loss of confidence, and social unrest.
In summary, in a purely fiat currency regime a sustained monetary inflation or deflation is an outcome of policy decisions regarding fiscal policy, monetary policy, and economic balance and output.

As long as the government is able to generate debt, deflation is a highly unlikely outcome. And when the government reaches the practical limits of debt creation, the underpinnings of the currency give way and the economy tends to collapse in a stagflationary slump.
There are no predetermined outcomes in a fiat monetary regime. Deflation, stagflation and hyperinflation are not 'normal' but are certainly possible if the central authority is permitted to abuse the real economy and the money supply for protracted periods of time.
What about Japan? Japan is the perfect example of a policy decision made by a fiat currency regime in what was decidedly NOT a free market, but under the de facto control of a highly entrenched bureaucracy, a single political party, and large corporate giants in pursuit of an industrial policy that favored exports and domestic deflation.
The difference between the Japan of the 1980s and the US of today could not be more stark. Choosing a deflationary policy and high interest rates as a debtor nation is economic and political suicide. It would be interesting to see what happens if the US elites try to take that path.
We will know if there is a true monetary deflation in the US because the value of the dollar will start increasing dramatically with regard to other hard assets, other currencies, goods and services, and precious metals and commodities. Prices will decline especially for imports as the dollar gains in purchasing power.
Remember that a true monetary inflation and deflation would only show up over time. Even in the Great Depression in the US, as demand slumped and prices fell, the stage was set for a significant devaluation of the US dollar and a rise in consumer prices well in advance of the eventual recovery of the economy that caused the Fed to tighten prematurely. As I recall the actual contraction in money supply lasted two years. This again highlights was an amazing piece of bad policy that Japan represents in its 'lost decade.'
People embrace beliefs for many motivations. So often I find they are not 'rational' and based on a scientific study of the facts, even on the most cursory level. Fear and greed and prejudice are often motivations that are surprisingly resilient, even in the face of overwhelming evidence against them. Leadership understands this well.
There are often appeals to private judgement. I do not care what you say, this is what I believe, what I think, what I feel. This is appropriate in the supra-natural realm, but in the natural realm there may be private judgement but the facts are public, and the outcomes are well beyond the complete control of the most fully-managed perceptual campaigns, at least so far in human experience.

"The lie can be maintained only for such time as the State can shield the people from the political, economic and or military consequences of the lie. It thus becomes vitally important for the State to use all of its powers to repress dissent, for the truth is the mortal enemy of the lie, and thus by extension, the truth is the greatest enemy of the State." Joseph Goebbels, of the perception modification school of economic thought

What is truth? It is difficult to estimate but not completely out of reach.

Our own view is that a serious stagflation with further devaluation of the US dollar as it is replaced as the world's reserve currency is very likely, after a period of slackening demand and high unemployment. A military conflict is also a probable outcome as countries often go to war when they fail at peace.

Weimar was not an anomaly although the level of inflation was indeed legendary. Argentina, post Soviet Russia, and most recently Zimbabwe are all similar examples. Serious Instances of Monetary Inflation Since World War II
There are many, many variables in play here, and policy decisions yet to be made. It is highly discouraging to see Obama's Administration fail so miserably to do the right things, but there is always room for hope, less so today than six months ago however.
Argue and shout grave oaths and wave our hands though we might, we are in God's hands now.
Let's see what happens.
A very special thanks to our friend Bart at Now and Futures who makes these charts, among other things, available on his highly informative web site for public review. If you are not familiar with his work you might do well to view it. We do not always agree, but he demands attention because of the rigor which he applies to his work for which we are grateful, always.

Via:  Market Ticker  If you’ve wondered what the fuss about CDSs is, read this. 

Congress has no more excuses

If you haven't seen this, you need to. 

Christopher Whalen is a principal of a firm that rates the performance of commercial banks, Institutional Risk Analytics.  I have featured some of his writing before in Tickers, but this one, submitted to The Senate Committee on Banking, Housing and Urban Affairs yesterday, takes the cake.  You must read this in full but for those who are incapable of understanding it, I'll spell out details for you.  Some excerpts:

Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants.

Translated: The banks make extra-large profits by extracting money from other people in the rest of the market.  That is, they have effectively been given the power to levy a tax - something supposedly reserved to Congress.

The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C).

Worse, when they blow it, you eat it, not they.  Why?  Because they have effectively bribed the regulators to speak on their behalf and for their interests, much as allegedly happened with Stanford and the so-called Antiguan banking regulator.

With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ "models" that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see – and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form.4

The dealers, the large half-dozen banks that control this market like a cartel, basically making it all up.  There is no actual underlying pricing and therefore the price is whatever their computer model says it is, and you can't see it.  Only they can, and they use this against everyone else to effectively rip off everyone trading with them.

Let's be clear: Chris is using one example here where the dealer (the big bank) is the SELLER.  But there are also cases (e.g. AIG and Goldman) where the big dealer is the BUYER; the seller is in fact selling SHORT, effectively, a product that the dealer has exclusive control of the pricing and model on by which their gains or losses are calculated!

In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

The clear version of the above, in English.

To put this in "Joe Six Pack" speak this "market" is exactly like playing Blackjack against a dealer who has a supply of aces and kings under the table, and uses them to deal blackjacks to himself any time he would like.

Would you knowingly sit at such a table?

It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.

And let's not forget who gets all the money.  JP Morgan, Goldman,

Seen in this context, AIG was the most visible "sucker" identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.

Any questions?

Chris has been one of the consistent bright lights in this mess since it began.

I have called for all swaps and other OTC derivatives to be forced onto an exchange.  Why?  In no small part because I know that not all derivatives can be exchange traded, and should this be forced all the "sham" products would be immediately exposed for what they are and eliminated from the marketplace.  Those that are legitimate products would trade with transparent pricing, open interest and volume, thereby contracting spreads to a reasonable level and eliminating the ability of the cabal of dealers to screw their customers.

Items like FX and Interest-Rate swaps can easily be exchange traded, as the closing price can be computed daily and for most of these products a minute-by-minute price can be computed using transparent and simple formulae.  The underlying instruments for these products are real and trade every day - interest rates of course are a matter of public knowledge and trades in the treasury and agency debt market, while currency pairs are quoted on a near-continuous basis.  Both sorts of OTC contracts have no real reason to change hands over-the-counter, except to allow some bank to insert a hinky clause here or there that disadvantages the customer, charging an outsize spread or commission for the "privilege."  Indeed there have been several major disputes over this practice between these banks and municipalities that were sold complex interest-rate swaps that in some cases came with allegations of outright bribery or inside dealing.

But when it comes to these other things like CDOs and CDS, there is no observable market price on which to base the derivative as there is no actual underlying basis.  What, for example, is the "risk that GE will go out of business in the next year"?  Document how you arrive at your answer please, and good luck coming up with anything that is objectively defensible.

In short, the nonsense, patronage and outright fraud within both our government and the cabal of dealers must stop now.

This marks two warnings Congress has had on this matter in written testimony, the first prior to the repeal of Glass-Steagall predicting exactly what has now happened and now, this from Mr. Whalen.

I have written to Congress on many occasions, including spending thousands of dollars faxing Tickers, white papers and other documents to all 535 members over the previous two years on these points.  Congress seems to think that America is a bunch of dolts and will tolerate being literally stuck up at gunpoint to the tune of hundreds of billions if not trillions of dollars in a massive collusive scam that reaches all the way to the top of the American Regulatory and Political Systems.

The American people have every right to hold The Board of Governors of The Federal Reserve, The Federal Reserve Bank of New York, Henry Paulson, Tim Geithner and all 535 Congressional members personally responsible if the abuses, frauds, and scams that have been enabled by the intentional blindness and even complicity of these individuals are not stopped immediately and all past transgressions prosecuted to the fullest extent of the law.

We the people have every right to demand and expect that a passel of special prosecutors be empaneled immediately to go over each and every one of these allegations, investigate every agency including The Federal Reserve and its member banks, and where appropriate bring indictments and prosecutions for frauds perpetrated upon the taxpayers, investing public, the states and municipalities of this nation.



  1. Great post. Thanks for the tips on how to survive. I totally agree on your conclusion and hope you are not let alone in your demands.

  2. Here is the main reason why we would not get inflation despite the current mainstream belief that the dollar is weak and fiat currencies. People want to increase their (dollar demoninated) savings and pay off their (dollar demoninated debt.)

    Essentially people risk their lives to collect the "intrinsically worthless" Federal Reserve Notes. Legal tender laws do make the "intrinsically worthless" pieces of paper quite valuable during deflation since it can be used to pay taxes and debts:

    "Two narcotics suspects have been arrested after leading police on a wild chase, tossing
    out more than $17,000 in cash out of their truck’s windows as motorists stopped freeway traffic to grab the bills.

    The pursuit began Thursday afternoon when police and federal drug agents followed two men who drove off in a pickup truck, Drug Enforcement Administration spokeswoman Eileen Zeidler said.

    The driver took officers on a circuitous route over several streets and freeways, eventually getting onto Interstate 5 at the height of rush hour. On the busy freeway, the suspects flung mostly $20 and $100 bills out of the truck’s windows before surrendering to authorities.

    As the cash blew across lanes, motorists slammed their brakes in the middle of the road and scrambled to pick up the bills, police Sgt. Kevin Rausis said."

    Unless Bernanke shows an interest in monetizing the debt significantly (this happened in Weimar, but not in Japan), you'll have deflation. Maybe China might stop exporting goods to us and the price of imported manufactured goods would go up, but the excess capacity would cover that (although it would be more expense than imported goods.) An oil shock would raise prices though. I do think the foreign dependency would raise prices if resources were cut off increasing their scarcity value.