Not Now John.

Not nah John
We’ve got to get on with the film show.
Hollywood waits at the end of the rainbow.
Who cares what it’s about
As long as the kids go?

Roger Waters

In 1991 the Japanese economy busted after over a decade of booming prices in capital and durable goods. The housing boom is paramount, with mortgages running for as much as 99 years. The only way a famuly could afford to buy a house was if their grandsons picked up the tab. We were told there was no way house prices would go down in Japan because of the lack of available space, but this was not the reason why prices surged. The reason was a credit expansion.

There is nothing wrong in promising to pay for a present good with future goods yet to be produced but we must admit there is some uncertainty in the whole affair. If someone is willing to wait for 99 years to get their principal back (at least the last installment) then that person (and his heirs) must be willing to endure a lot of uncertainty in the process. Now, the fact the debt itself became an asset that could be freely exchanged in the market, might have served as an incentive for people to engage in such transactions, but in the end, those assets must remain with someone willing to hold them and take the risk. Or so it should if there wasn’t a lender of last resort that will either buy that asset at face value outright or accept it as collateral for more loans.

As it turns out, in Japan, there was no one available to keep those assets at the prices required by their owners, that is, the banking system. Instead of allowing their liquidation, the BoJ came in and bailed-out the banks. The irony is that in the US a lot of people scorned the Japanese Way, saying no way this would happen in America. In the land of the brave if a business has to fail it does. They were perhaps naïve, believing the legacy of the Founding Fathers still ruled the country in the 1990’s when, in fact, it has been slowly but surely set aside ever since the moment it was written in paper. Americans didn’t have to wait long. In 1998 the LTCM went bust. We must remember this was a company put in place to arbitrage – or so they thought – “inefficiencies” in asset prices. There is definitely some hubris in the whole affair, investors paying the price for defying the gods of science. Their sin: the pretense of knowledge. But if investors were wiped out, all those allowing them to build such massive positions were not. The financial system was crammed with moral hazard and no effort was made to purge it, quite the opposite.

And this brings us to 2008, Lehman and the supposed need for QE to prevent the meltdown of the financial system. American investment banks held assets of very dubious quality. They represented future promises of payment that were going to be partially or wholly defaulted. In order to keep the value of those assets, the pricing system had to be perverted and prices are a fundamental part of economic coordination. What is being achieved with QE is that similar investments (other than subprime for obvious reasons) will continue to be made. If liquidations had been allowed, the capital goods (and claims on capital goods) held by the banks would have been purchased by investors at prices that would have allowed those same goods to have been put to better (or more economical) uses. QE worked to prevented any possibility of recovery from taking place. It channeled and forced (through taxation and regulation) individuals to finance inadequate capital structures and business plans. Now we face an over-twenty-years-ongoing recession. And that is the best case scenario.

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When Israel was on the GDP Land…

Yesterday I said I was not impressed with the fact that QE helped in sustaining GDP. Today I hope I can help you understand why. Here it goes: GDP is just a number. Somewhere back in the 1930’s somebody though it was a good idea to measure the wealth produced by a nation by measuring the aggregate production, expenditure or income. Nothing wrong with that of course, assuming every individual is working to satisfy their own needs (and before you mention, these needs can be altruistic). A slave working in a plantation is adding to the GDP but we can arguably say he is better off. But even voluntary work has its setbacks. Maybe the work is voluntary but somebody ended up paying the bill unwantedly.

We can gaze at the pyramids in wonder yes, but most of us are glad we did not have to build them. As far as we know the workers were paid, but somebody had to pay them and if that was achieved by taxation it means a multitude of individuals were hindered in their pursuit of their own happiness just so the pharaoh could have a safe journey to the after-life. In reality I cannot weight this august end against a multitude of others (although I have a strong opinion about it), but then again nobody can. To assume the fact GDP held off was good for the economy is assuming the “wealth” it measures is actually wealth.

Maybe, the Egyptians were proud of their pyramids and happy to finance the effort. The empire lasted for thousands of years (with a lot of turmoil in between) and even if the emblematic gigantic pyramids were the product of a short span of time (perhaps an indication things had gone too far?) a lot of smaller pyramids were built. So probably pyramid building was akin to a national pastime and not the best of examples. I don’t want to give the impression that, since I value the pyramid function as valueless, I believe the pyramids themselves were valueless for the ones who built them.

Tintoretto, Solomon and the Queen of Sheba (1545), Gallerie dell'Accademia, Venice.

Tintoretto, Solomon and the Queen of Sheba (1545), Gallerie dell’Accademia, Venice.

I’ll use one of my favorite examples instead: that of wise king Solomon. Never before nor again did the Kingdom of Israel reach such a territorial extent. Furthermore, it seems Solomon was a ladies man, and quite successful too. According to the Bible he had some 700 wives and 300 concubines making a fine consumption pushing those GDP figures rather extraordinarily. King Solomon is also universally known (and praised) for restoring the Temple yet, undoubtedly he feared what the idleness of excess capacity in the construction sector would do to his economy. He set to build a network of palaces to provide shelter for a) his enviable harem, b) the consequently numerous offspring and c) the necessarily large amount of eunuchs that reassured him of the legitimacy of the majority of that same offspring. It could be said that wise king Solomon built a cluster of activities that prevented aggregate demand from depressing the economy. He also engaged in multiple military operations to extend and defend his and his predecessors’ territorial gains. What else could the man do to fight depression and unemployment?

Some might call it a coincidence, but when old king Solomon died, the Northern Tribes refused to acknowledge his son Rehoboam as their ruler. This is a bit odd. His father was the wise King Solomon and his grandfather the heroic King David, why would they hold a grudge against him? They didn’t, they just feared he would continue to tax them heavily like his old man had been doing for so long. So they refused him and both Kingdoms, Israel and Judah, went separate ways.

I don’t mean to imply Solomon was not wise. He most likely was, as he managed to live in luxury for his entire life. But the country could not support such a lavish lifestyle even if GDP never looked better. Austerity necessarily followed and his poor son had so settle for just 18 wives and 60 concubines. I almost pity the poor old fellow.

On Rational Expectations

Today I came across Niels Jensen’s The Absolute Return Letter, via John Mauldin’s weekly newsletter Outside the Box. It is a very interesting piece of work that I definitely recommend everyone reading. You can find it here http://d21uq3hx4esec9.cloudfront.net/uploads/pdf/2013_12_03_OTB.pdf

Jensen argues that QE is a dangerous experiment and I couldn’t agree more. He says that it is inherently deflationary and, although I disagree, I know this is only due to a different definition of inflation. Yet, he starts by telling us that QE was the right call and it was only the extension of this program (QE2, QE3/4 and other non-standard measures) that turned it into something harmful, and this is where I cannot follow his argument. In fact I don’t seem to find one, just a conclusion from what some might consider empirical evidence.

According to Jensen, the first QE prevented the post-Lehman financial meltdown while sustaining economic growth in terms of GDP growth. Again it is not so much that I don’t agree QE managed those things (it seems I am only making it worse for myself) it is that those things are extremely overvalued. To make my point I would have to go through a lengthy, yet hopefully entertaining, process. So I will do that probably tomorrow.

Meanwhile, so I don’t leave you completely empty-handed I will just say something about the “rational expectation hypothesis”. Jenson, again correctly, mentions inflation expectations as an important part of price formation in interest rates (It is very hard not to agree with the man). He argues, or so the hypothesis leads to conclude, economic agents make rational decisions based on expectations, thus when central banks say they will keep interest rates low, economic agents postpone their borrowing decisions.

Far from me to want to imply economic agents act irrationally. If anything, I would defend the opposite: individuals cannot act but rationally. My problem with this hypothesis is that it implies that by acting rationally they would all act the same way, t.i. the “right way”, as if differences in cognition, quality of information, past experience, etc. would not make each agent unique and their responses to the same piece of isolated economic data diverse.

True a central bank stated policy works in a way to try to homogenize interest rate expectations, but one thing is what central bankers aim at and a very different thing is what they achieve. The postponement of borrowing due to the expectation of lower rates in the future would not, in theory, prevent borrowing from taking place. We all know computers go down in price or, alternatively, a new more powerful model comes and replaces the old one for the same price. In reality we do not know this, we have expectations that this will continue to happen in the foreseeable future. Yet everybody would rather achieve their goals sooner than later. Individuals possess a time preference that impels them to act to achieve their goals rather sooner than later. Having a computer today is worth more than having one in the future for people who value it as a means to achieve an end, or as an end in itself. Cheaper computers in the future do not prevent people from buying one today. Some people wait for a better or cheaper model but prices on the current models don’t go down until the arrival of the new model (and its wholesale price) is a near certainty.

To postpone a business opportunity today (that by some reason some seem to believe is ready to happen tomorrow) has an opportunity cost that must be taken into consideration. It has to be lower than the expected benefit accrued by those expected lower interest rates. It is a lot of expecting to do and uncertainty to endure. Some potential investors might be doing just that, but it is probably simpler and more accurate to assume no such business opportunities abound than to believe they are waiting for lower interest rates to be grabbed.

The Card Players

 If we take a random look at the economic stats of lately we can quite reasonably assume the global economy is on the rise again. Not only that, also the financial industry is hiring people and assets under management are growing, not only due to rising asset prices but also because money is coming back from deposits and other supposedly “safer” investments.

A month ago or so I read a long-term forecast that said the World GDP could rise to as much as 100 trillion in five to seven years time. I cannot disagree even because GDP is just a number and one to which governments around the world pledge significant resources. I sometimes find it hard to believe the amount of wealth that can be destroyed just to make that number rise by a couple of tenths. But then again, it is not their wealth to start with.

Well my question is not if we will reach that number but rather how much is deemed necessary, on average, in global growth of asset prices, for the combined GDP of world countries to reach 100 trillion y 5-7 years?

For the time being things look good, with QE’s excess liquidity being channeled to Paul Cézanne, Francis Bacon or Andy Warhol works of art. I must admit it is mighty clever of those art purchasers. They are acquiring unique pieces of human ingenuity by delivering a very large quantity of reproducible-at-will pieces of…well…digital bits and bytes. Those pieces, in turn, are backed by assets (namely debt) of dubious quality kept in central banks mainly to achieve the transfer of wealth from productive individuals to capital structures inadequately built to satisfy human needs (the worst of all, as we very well know, is called “the government”).

Paul Cézanne, The Card Players (1892/93), Private Collection of the Royal Family of Qatar. Acquired for 250 million dollars in 2011.

Paul Cézanne, The Card Players (1892/93), Private Collection of the Royal Family of Qatar. Acquired for 250 million dollars in 2011.

 

Not only those few fortunate investors can gaze at the excellence of those few works of magnificent art, but fine paintings come with the additional advantage of transportability.  They can be carried around and put to rest faraway from the greed of bureaucrats and politicians. Something digitalized property claims, also known as financial assets, cannot. Could it be a coincidence that the first country to replace the use of a piece of paper to signify ownership of financial assets for a central clearing entity that just transfers registrations of ownership was Nazi Germany?

But the best thing is Francis Bacon’s paintings and Andy Warhol’s photos, like common shares, have a zero percent weight in the CPI so we can all pretend nothing is going on.

The Funk Soul Brother

The other day I got to see this graph. I’m sorry I cannot say where it comes from but I got it in a e-mail that somebody sent to somebody who, in turn sent to somebody else. Over and over, so I’m afraid I cannot give due credit to the author.

S&P vs Balance sheet

Anyway, I believe the reality it describes is pretty much clear to everybody: ultimately the increase in Fed’s balance sheet is not only sustaining but also driving up equity prices. This is the helicopter theory at its best, the fundamentals behind the rally ever since March 2009.

In reality it is not such a clear cut deal. The Fed began its balance sheet expansion before equity markets did pick up. At first, most investors run for cover and prefered hard currency to uncertain ventures. It is only when they began to trust business as usual would find support that they gradually came back. But, what about now? (The funk soul brotha, right about now…)  Back they are, so how come the FED is not reversing their policy?

The answer is, of course, it can’t. I know there are talks of taper but talking is cheap. What the balance sheet expansion aims at is to make interest rates low enough to make any financial asset an attractive investment, irrespective of how low its productivity is in satisfying human needs. If leveraged the better. There is no turning back. Massive savings are now supporting expensive and hardly profitable capital structures. The largest and less productive of these is called “the government”.

I do not know if this is an intended or non-intended consequence of central bank policy (I suspect the later), but I do know that the only way for governments to keep their promises to creditors, voters and supporters alike is by exacting more resources, a.k.a. wealth, from their subjects in the future. Those wealth producers, in turn, will have less to go around with. Believing the possibility of creating virtually infinite amounts of money (more accurately money substitutes) equates to being able to almost infinitely increase capital is an illusion. It ignores the decreased quality of that specific capital good that is being “produced” in exponential amounts. The rally will continue for as much as the illusion that wealth is being produced is maintained. New ventures backed by promises of future wealth will be issued, while in reality capital is being destroyed/malinvested  throughout the whole process.