There Are No Policy Remedies for Debt Deflation
"He became a surgeon because he was afraid of knives. He got married because he was afraid of women. He had a child because he was afraid of responsibility. Now his marriage over and his childno longer speaking to him, he turned off all thelights in the house because he was afraid of thedark."Michael Ventura,
The Zoo Where
You’re
Fed To God: A Novel
Michael Ventura made me write. He confronted mewith uncomfortable questions that have noanswers. Do I write because I'm afraid of writing?Did I become a hedge fund manager because I'mafraid of risk? Is Bernanke set to wreak economichavoc in the twenty-first century because hemisunderstands the malaise of the early twentiethcentury? In truth, the quote emanates from a bookthat I bought over the summer when I mistakenlyread its title as
“
The Zoo Where The Fed Is God,
”
Ithought it sounded like a contemporary narrativeon
today’s
risk markets. But it has succeedednonetheless in motivating me to share my thoughtswith you once more. However, I must warn you thatmy views have not changed. Therefore some of youmay wish to look away now.
I Sing The Body Eclectic?
As you know, I have not written at length for sometime. You need to understand that my timing isheavily influenced by both the push and the pull of Robert Prechter and Walt Whitman. Prechterbecause he recommends that one should writemore when certain and less when uncertain. Like Isaid, nothing has really changed and consequently Ihave been in no rush to repeat myself. To meWhitman is influential because he spoke like ahedge fund manager ought to:
“all
faults may beforgiven of him who has perfect
candour,” “be
curious, not
judgemental,”
and my personalfavourite,
“have
you learned the lessons only of those who admire you, and were tender with youand stood aside for you? Have you not learned thegreat lessons from those who braced themselvesagainst you, and disputed passage with
you?”
Butthe clincher, for me at least, was his life-longendeavour, a book of poems he entitled
Leaves oGrass
, which he periodically updated, republishedand embellished as he grew older and wiser. Thinkabout it: one book, one life. I would like to thinkthese investment letters are written in the samespirit.Described as a courageous attempt to weave,
“the
muscle of the male and the teeming fibre of the
female,” Whitman’s
poems succeeded, of course,only in shocking their prudish late nineteenthcentury audience. I fear that just as
Whitman’s
musings on sex and sexuality seem rather tame tothe modern eye, a later generation might feel thesame way about our squeamish reaction to the
Fed’s
initial stab at quantitative easing. They mightguffaw,
“two
trillion dollars, how quaint. And theythought that might produce
inflation!?”
For a not sodistant future generation may bear witness to fargreater monetary debauchery.This has been my argument in April 2009. Given theimpediment of such a large quantity of privatesector indebtedness, I speculated that should theglobal economy suffer a further debilitating setbackover the course of the next two years, the Fed andespecially its acolytes at the Bank of Japan wouldprint much, much more paper money. And onlyunder such dramatic economic circumstanceswould we establish the pretext for a truly giganticmonetary intervention which would surelyundermine the fiat system.Today, however, we are learning that additionalmoney, perhaps $600bn, is to be printed evenwithout the occurrence of a serious crisis. This hascome as something of a surprise to me. I hadthought that intense scrutiny and politicaldiscontent from the US Congress would havetempered the ardour for such intervention. The QE
THE ECLECTICA FUND
Manager Commentary, December 2010
announcement has also produced a rise in the riskpremium associated with term structure. The yieldon the ten year Treasury has shot up from justunder 2.5% in August to almost 3% in November.Yields on government bonds with shorter tenors(where we have directional exposure) have alsobeen dragged up as the market factors in aheightened probability that QE2 will lead to a rise inpolicy rates sooner than had the Fed shown greaterrestraint. This has proven detrimental to the Fund'sshort term performance. Yet despite it all, I remainpersuaded by the argument that the additionalproposed easing is not a tipping point andaccordingly on its own is unlikely to do much toalter the course of US or western inflation. Perhaps Ihave some explaining to do.
War!
Evidently there is an all-out war being wagedbetween what we might refer to as the
Fed’s
fiatmoney (the ability to increase dollar bankingliabilities), and the private
sector’s
debt-basedmoney (the willingness of the private sector to holddollar banking assets). The market favours theprospect of fiat printing winning. Perhaps theoutcome is a foregone conclusion. However, Icontinue to argue that the odds seem stackedagainst this outcome occurring in the short term.Consider that the US authorities are battling againstthe $34trn of gross debt added by the privatesector since the start of Greenspan's tenure as Fedchairman in 1987. This is a formidable obstacle toquantitative easing as it added only $9trn to incomeand has therefore left the private sector withmisgivings as to its on-going ability to service such ahuge quantum of liabilities, never mind add to suchexposure. The crucial question is how much of thislift in income is a recurring flow, a product of wiseinvestment spending, and how much was debtfuelled asset speculation with little capability of servicing interest payments and principalrepayment. This is especially pertinent because, asthe chart reveals, despite the helicopter moneydrop of last year, the ratio of private sectorliabilities to Fed-induced base or fiat money (M2)remains elevated by historic standards. Forinstance, it is twice the level that prevailed in the1960s and three times the level of the 1950s.No one has really addressed this issue exceptProfessor Steve Keen in Australia, who is starting towin much justified acclaim. He compellingly arguesthat some form of aggregate demand analysis isespecially apt in describing why the
Fed’s
initialdalliance with $2trn was insufficient. Definingdemand, or total spending in the economy, asnominal GDP plus the change in gross public andprivate sector debt, total spending in the US shrunkfrom $18.2trn in the year concluding in the summerof 2007 to just $13.9trn this year. Effectively, the USeconomy has spent $4.3trn less on the purchase of goods, services and assets (houses, shares, hedgefunds, private equity investments, etc.) despite therise in gross debt from $47.5trn to $52trn. In otherwords, monetary and fiscal accommodation havebeen overwhelmed by the 10% contraction (muchof it involuntary and taking the form of default) inthe private
sector’s
debt-to-GDP ratio from its peakof 3x in early 2009.Recognising this vulnerability, the actions of the Fedsince the onset of the crisis are easier tocomprehend. With such a large quantum of debt itwas imperative to reduce the cost of servicing it.Policy rates were cut to zero. However, the
Fed’s
aggressive interest rate cuts had only a mild impacton the servicing of household debt in America withits preponderance of callable fixed rate mortgages.The effect was more pronounced in the UK wheremortgage lending was predominantly variable andrates were previously priced off the one-year swapwith only modest additional term and counterpartypremium. Arguably, the institutional differences
2
The Eclectica Fund: Manager Commentary, December 2010
0%50%100%150%200%250%300%350%
1 9 6 0 1 9 6 4 1 9 6 8 1 9 7 2 1 9 7 6 1 9 8 0 1 9 8 4 1 9 8 8 1 9 9 2 1 9 9 6 2 0 0 0 2 0 0 4 2 0 0 8
Domestic Private Debt to M2
Source: Federal Reserve
between the two
countries’
mortgage marketsmade QE almost inevitable, in the US at least. Lastyear the Fed bid for probably a third of theoutstanding stock of ten year Treasuries; the
Fed’s
holdings climbed from $450bn in early 2008 to$767bn at present day. But they had to concentratethe majority of their ammunition on purchasingmortgage backed securities, buying over a trillion
dollars’
worth, to ensure that the cost of servicingthe household
sector’s
debt would not rise on theback of elevated risk aversion in the banking sector.I salute this round of easing.
Fooling All of the People, All of the Time
Unfortunately, in my humble opinion, the additionalmonetary stimulus, takes the Fed back to dancingaround a bubbling cauldron rubbing two chickenbones together. For flush with their success inhaving reversed the negative trend in nominal GDP,the
Fed’s
ambitions seem to have soared. Bernankehas publicly reasoned that they should go furtherand boost the
economy’s
animal spirits in order toincrease aggregate demand in the economy. Theimplicit thought process is that if they could onlyencourage the private sector to believe that thetrend in rising asset prices will endure then perhapsspeculators will once more volunteer to risk takingon more debt, secure [?!] in the belief that higherfuture asset prices will allow for it to be repaid infull. This reasoning, whereby the stock market actsas a contributory factor to GDP growth, invokesparallels with Thomas Huxley's
The Principal Subjects of Education
. Sometimes it seems that nextto being unequivocally correct in this world, the Fedhas concluded that the next best of all things is tobe clearly and definitely wrong.Capturing this unrepetentantly bullish autumnalmood, the Greek finance minister, in Washingtonfor the annual IMF meeting, opined that, "smartmoney is realising Greek bonds are a goodinvestment." Remember this is the same guy whosaid, and I quote,
“we
are deluding ourselves as acountry in thinking we have a tax
system!”
Politicians and their central banking cousins are of course the ultimate expression of the prevailingconsensus. The finance minister had no doubt beenbuoyed by the decline in Greek ten-year bond yieldsfrom 11.7% at the end of August to just below 9%and the
FOMC’s
confidence was likewise lifted bythe slide in the ten-year yield from 4% in April 2009to less than 2.5% in the weeks preceding their lastmeeting. But with Greek yields back at their highs,Ireland sinking into the mire, the solvency of theentire European banking sector in question andTreasury ten-year yields challenging 3%, it makesme think that the character Vernon God Little, fromDBC
Pierre’s
novel had it right when he said:What
I’m
learning is the world laughs through its assevery day,Then just lies double time when the sh*t goesdown
…
The Rule of Society by the Wealthy
My greatest complaint however is that the Fed isproducing a plutocracy by demonstrating that theyare willing to go to all lengths to prevent a marketinspired liquidation of the
economy’s
bad debts.This is what happened in Weimar Germany. Hugeprivate fortunes were amassed during a time of little economic prosperity, exactly what hastranspired in recent years in Britain and Americawith the rise of hedge funds and private equityfirms. Success with money has become intimatelyconnected with inflation
–
people have got rich notthrough productive, wealth-creating activity, butbecause they bought a house or stock at a timewhen general asset prices were rising. We haveconfused talent with being bullish.Into this fray stepped a prominent and hugelysuccessful (if somewhat uncomfortably brash)hedge fund manager who proclaimed himself theleader of this red-light gang. In his call to arms heclaimed that making money was "so easy" and
“youcan’t
lose.
”
You see, he has influential friends at the
3
The Eclectica Fund: Manager Commentary, December 2010
05101520253035
9 0 q 1 9 1 q 1 9 2 q 1 9 3 q 1 9 4 q 1 9 5 q 1 9 6 q 1 9 7 q 1 9 8 q 1 9 9 q 1 0 0 q 1 0 1 q 1 0 2 q 1 0 3 q 1 0 4 q 1 0 5 q 1 0 6 q 1 0 7 q 1 0 8 q 1 0 9 q 1 1 0 q 1
Debt Service as a % of Disposable Income
US UK
Source: Federal Reserve/UBS
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