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A big rally on Wall Street today as the bond market was closed for Columbus Day. In other words the adults stayed home. So stocks had their way on hopes that Merkel and Sarkozy would come up with a feasible plan to take the French and German bank debts on to the public balance sheets, or at least whichever part is not served up as a haircut to bondholders and bank shareholders.
The US is keenly interested in this because despite assurance otherwise the contagion and counterparty risk with Wall Street is significant.
Volumes were very low so the rally was not as impressive as one might imagine. But the shorts were there and they were squeezably soft and overexposed.
This will likely continue to be an event driven market and when the events subside, then the gimmicks and technicals of the traders take over.
I think this is an important essay from Michael Burry, excerpted below, about the financial crisis, and so I share some extended excerpts with a link to the original. Keep in mind that this is one perspective from a particular point of view.
For a more comprehensive and balanced view of the causes and progress of the financial crisis I highly recommend Econned, by Yves Smith. I have given copies of it to some of the older children, to help them understand what has happened and what they will face in the future.
With regard to the policy stalemate, there are obvious tradeoffs between growth and taxes and spending cuts, and the ways and phases in which one introduces them. Those fortunate few, who have one point of view about reform and the distribution of losses, have a dominant voice in the mainstream media. Others are beginning to speak up and show their disgust and displeasure with the status quo.
As he points out the Greenspan decision to stimulate the economy with rates cuts, and thereby fuel the housing bubble, keep in mind that at the same time the Bush Administration was initiating two wars and providing tax cuts for their wealthy constituents. It might be considered a perfect storm if it was all accidental and coincidental. I personally think it was not.
But it does show what happens when one engages in massive stimulus after a financial crisis, Y2K and the tech bubble, without also reforming the system and prosecuting fraud. There was yet another asset bubble, further plunder taken, and greater debts left to the public.
History may very well regard both The Patriot Act and TARP as key pieces of legislation, pushed through hastily under the duress of a crisis, that proved to undermine the stability and health of the Constitution and the republic.
The intense lobbying and buying of political power that set the financial bubble in motion in the 1990's under Clinton led by team Greenspan-Rubin-Summers is still underway. Those who are sitting on large piles of loot obviously wish to keep it, and shift the blame and the pain to others. It will be a divisive time until this is resolved.
I doubt very much that the resolution will not include de facto defaults and devaluation of currency. It is only a question of how targeted they might be and who those targets are. Right now the middle class and the poor are 'not winning.'
The author acknowledges the key problem we face today, and that is the complete failure of the leaders of the system to acknowledge the problem and take the appropriate actions, because they are deeply complicit in the corruption and malfeasance that led to the crisis and a generational transfer of wealth from the many to the few.
Vanderbilt Magazine
Missteps to Mayhem
By Michael Burry
"...Our global village underestimated many risks throughout the 1990s, as is typical of a generally good economic time. As we faced 9/11, the stock market crash of 2002, the Enron and WorldCom scandals and eventually war, the Federal Reserve Board stepped in, cutting the discount rate it charged lenders from 6 percent to roughly 1 percent in order to stave off recession. Other key short-term interest rates followed.
Not coincidentally, from 2001 to 2003 we saw American home prices, which had largely moved in line with household income through the decades, suddenly accelerate up and away from the household-income trend line. Rapidly declining short-term rates hit lows not seen since the aftermath of the Great Depression, inducing a boom in adjustable-rate mortgages.
The homeowner’s dollar went further during that teaser-rate period, so home prices rose unnaturally. Risk would be low as long as home-price appreciation was strong under this paradigm, thanks to refinancing options.
It was a positive feedback loop with the full blessing of the U.S. government. Amid early fears that the housing market was getting ahead of itself in 2003, Federal Reserve Board Chairman Alan Greenspan assured everyone that national bubbles in real estate simply do not happen.
I disagreed. As I surveyed the national trends in housing, I wondered whether common sense ought to rule against the application of precedent to the unprecedented. But Greenspan went on to advise in 2004 that new types of adjustable-rate mortgages were being underutilized. In 2005 he allowed technology used by subprime lenders to get subprime borrowers into homes. Tragically for all of us, the Federal Reserve had authority to block lending activity it deemed unworthy of such treatment, but it had no will to do so...
By fall 2004, I noted for my investors that Countrywide Financial, a very large national mortgage lender, was reporting subprime mortgage originations up 158 percent year over year, despite a 24 percent decline in overall loan originations. Evidence was manifest: Banks were chasing bad credit, inclusive of housing speculators. The only question was how far they could go.
Ominously, fraud jumped. The point at which the provision of credit was most lax, in my mind, would mark the point of maximal price in the asset. I imagined the top end of the housing market would be marked by a climate in which borrowers of subprime quality were enticed to buy with teaser-rate monthly payments near zero. I was very aware lenders would take this to the nth degree. Banks could sell loans they did not want to keep through Wall Street, to investors who were ravenous for yield.
Importantly, because subprime mortgages were being turned into securities, there were mandatory regulatory filings—and that’s how I educated myself about the sector. At times I felt I was the only one reading these filings.
By summer 2005 these documents revealed that interest-only mortgages had taken a substantial share in the subprime market. Just a year or so after they were introduced, more than 40 percent of subprime originations were passing through Wall Street on their way to investors. This was up from 10 percent a year earlier. At the same time, second-lien mortgages ramped up significantly. Stated income options available to borrowers inspired a new vernacular: the “liar loan.” In some mortgage pools, 40 percent of subprime loans were for second or vacation homes...
Incredibly, it would be reported later that more than $60 trillion in credit derivatives were in effect at their peak. To use a bit of hyperbole: That is roughly equal to the gross product of the entire world. How could that be? Credit derivatives on an underlying asset could be worth multiple orders of magnitude more than the asset itself because all asset-backed derivative securities are settled in cash—pay as you go. That was the secret sauce of the Doomsday Machine.
And so the crisis unfolded, with the market providing a signal far too late. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson continued to underestimate the situation. I was apoplectic.
Paulson now claims that even if he had known what was going to happen, he couldn’t have done anything about it. He had just joined the U.S. Treasury in the summer of 2006. But he came from the top job at Goldman-Sachs, and once he was treasury secretary, he orchestrated government takeovers of AIG, Fannie Mae and Freddie Mac—absolutely unthinkable actions just a few years ago. Paulson was anything but an impotent tool, but if he actually felt that way, it is a devastating commentary on how our government works.
As books and articles about the crisis proliferate, it becomes clear that at nearly every failed institution and every relevant department of government, someone had insight every bit as good as mine, and in many cases better. However, none of these people was in the top job. That our CEOs, our governors and our chairmen did not see this coming, did not adequately prepare their constituencies, is an indictment of the manner in which we choose and enable our leaders...
I worry about the future of a nation that would refuse to acknowledge the true causes of the crisis. A historic opportunity was lost. America instead chose its poison as its cure, and the second “Greatest Generation” would never be born.
Today I expect the U.S. government to attempt continuing an easy money policy into the next presidential term—past the meat of the foreclosure crisis, and past the corporate and public financing humps that are upcoming. Junk bonds, incredibly, again are at all-time highs. Quantitative easing seems to be working for now. But this is an invalid validation of what America is doing, a Pyrrhic gamble. As we continue to debase our currency, Bernanke says he is not printing money. Yet I receive an email every day from the Fed saying we just bought another $7 billion or $8 billion in treasuries, monetizing the debt. The scope and breadth of quantitative easing raise severe questions about the Treasury’s needs.
Government borrowing of money for the purpose of injecting cash into society, bailing out banks, brokers and consumers, is an easy decision for a population that has not yet learned that short-sighted easy strategies are the route to long-term ruin. We never quite achieved the catharsis necessary to stoke a deep reevaluation of our wants, needs and fears.
Importantly, the toxic twins—fiat currency and an activist Fed—remain even more firmly entrenched with the financial reforms of last year. The Federal Reserve, having acquired new powers of regulation, has insisted that nothing in the field of economics or finance was of any help in predicting the crisis—period, no more comments. It’s a worthless conclusion that guarantees we’ll make the same mistake again and again.
We need better leaders, but frankly this isn’t going to happen. A problem cannot be solved if it is never acknowledged.
Taxes need to be raised, spending needs to be cut, and loopholes need to be shut if we are to have any hope of returning to a stable base. Home ownership should not be a policy of the U.S. government. The banking system needs substantial reform and bank breakups. Glass–Steagall needs a second run in a strong form. And 22.5 million public workers have no business unionizing against the taxpayer. The list of things that won’t happen—but should happen—goes on and on.
By 2020, interest expense on our national debt could very well exceed $1 trillion. All personal income taxes collected in the U.S. in one year do not total $1 trillion. Our country’s math is scary big, but even scarier is that it simply doesn’t work...
Read the rest here.
Yesterday it was Yves Smith who took Paul Krugman to task. And I defended him in that instance in the comments. But now alas it's my turn, and I don't take this up lightly. So I must think it is important.
And I do. Because a false premise is being used to justify a false conclusion and by extension a matter of serious public policy in an ongoing debate. And people are in the streets about it.
In a recent op-ed Way Off Base Paul Krugman says:
"I see some commenters reacting to the failure of major inflation to break out by insisting that inflation is defined as an increase in the monetary base — that is, the bank reserves plus currency that are what increases when the Fed “prints money”. As it happens, that’s wrong: very old dictionaries defined inflation as a rise in money and/or credit, but the modern usage is, of course, a rise in prices.
But that’s really a side issue. Nobody would care about the size of the monetary base except for the belief that increasing the base leads to a rise in prices. That’s not a question of definitions, it’s a question of your model of the economy."
For those unfamiliar with measures of money supply and the monetary base, see Money Supply: A Primer.
I don't know who these commenters are, but they *could be* those from the Austrian school, who tend to look to what they call True Money Supply. I would have to read up to find out what the anticipated lag times are between expansion and its aftereffects. It could also be from those who are forecasting hyperinflation, but those are few and I am not among them. My forecast has long called for a credit bubble followed by a financial collapse and stagflation as the most like outcome but it is no economic model, more of a judgement call. The variables are too many and too exogenous for any model that I could possibly devise. . Or the model Paul references could be just a strawman.
Except for the Austrians, and of course perhaps Paul Krugman when it suits him, I don't know of many rational financial people who would look to a very narrow measure of money supply, especially the Monetary Base, and expect a simple causal effect in prices over a short period of time of even a few years, in an ongoing great recession with a very low velocity of money and little lending. And of course the Fed is taking steps to ring fence their market operations. And it seems to be working.
I thought the allusion to 'old dictionaries' versus 'new dictionaries' was an appeal to an authority that does not quite work anymore, as if Economics is somehow making steady progress, despite its most recent terrible flop and sometimes scandalous behaviour. Yes Paul can point to a few timid warnings in old columns, but his models were remarkably silent in predicting the financial credit bubbles and collapse.
The answer of course is-- ta da, better models. And the definition is my shiny new model versus your old outdated model as I choose to define them. But at the end of the day, the ideal economic model dictates policy with pristine mathematical objectivity.
Adjusted Monetary Base, who could care about it?
Well, the Fed spends quite a bit of time on it, and those who understand anything about economics know that in periods when the financial system breaks down, especially from some excesses promoted by central bank economists, the Fed becomes the 'lender of last resort.' And what they are lending is money they have created by expanding their balance sheet. If they were only providing temporary liquidity the balance sheet would not be expanding in such a parabolic manner and more importantly, remaining there.
In other words, the Fed becomes the 'money creator' and provider of last resort, expending a significant amount of effort to prevent monetary deflation which they find to be against their mandate of what-- a stable money supply and rate of inflation.
The monetary base is a source of money, not broad money in public hands, which the Fed provides under the duress of stressful financial conditions, rather than mere economic cyclical turns. Which is fine, because that is their job as currently defined. And the Monetary Base is one way of measuring it.
The Monetary Base has a particularly long lead time, or lag as economists call it, before even large changes appear in the real economy in the form of higher prices and a money supply that is growing in excess of some organic demand. I am sure Paul is aware of the devaluation of the dollar and the dramatic expansion of the monetary base undertaken in the 1930's by FDR, and the rather dramatic change in trend for consumer prices that followed, albeit not only from that, but other price support programs.
There is definitely a kernel of truth in what Paul says. "By contrast, the model of an economy in a liquidity trap, in which big increases in the monetary base don’t matter, comes through just fine." And Ben and the Fed are managing their activity with an eye to targeting it to the banking system, and taking steps to keep it from moving into the broader money supplies too quickly.
Adding liquidity from the monetary base in the face of sagging aggregate demand is not having a profound effect on broad prices in the relatively short term. I mean, duh. If the model suggested this it is right.
But that does not imply that some connection is not there, that it is meaningless. What it means is that so far at least, the Fed is managing their quantitative easing reasonably well. Unfortunately so well that it is not having the desired effect on the real economy or the banking system for that matter, except that the zombies are still standing. Just because something is not yet a smoking ruin does not bring cause for celebration.
The Fed is 'bottling up' the expansion of the monetary base in the banks, and quite a bit more of it than we had suspected as eurodollars, money provided to banks overseas. And they stopped measuring eurodollars a few years ago in one of the broadest money measures, M3.
The Fed, and I assume Paul Krugman know all this, but believe that they will have the tools, and knowledge, and the latitude to reduce their balance sheet when the time is appropriate and the real economy and banking system recovers. 'Volcker did it.' And so can we, because the models say so.
What the Fed and Paul Krugman are really saying is "Trust us." And our models. And don't think that the BLS and the government are tinkering with the econometric measures. Are you kidding me? It takes a willful blindness to ignore some of the more egregious tinkering that the government is doing in the name of perception management.
As for the comment about 'printing money,' it was Ben himself that said, 'the Fed owns a printing press.' And he was telling the truth.
I am not a believer in True Money Supply and greatly prefer broader money supply measures. And I know what the Fed is doing is providing an inflation risk that they believe that they know how to handle when the time is right.
And I also know that inflation is starting to pop up in certain sectors and items. And why it is not a broad increase yet, which is what we might call inflation. With most of the increase in money supply flowing to a very few in the form of income, well, this is all understandable.
So what was the point of Paul bringing all this up? It was this.
"Here are the data — I’ve included commodity prices (IMF index) as well as consumer prices for the people who believe that the BLS is hiding true inflation (which it isn’t)"
Let's see. The BLS is not distorting inflation measures because the model is working, and we know the model is working because of the BLS inflation measures. That seems a little shaky to me. Especially in light of the other data that shows that certain price sensitive assets are rising in price, and sharply, in response to negative real interest rates, as some other models and theories would hold.
Yes the US is in a liquidity trap. And yes, the actions of the Fed so far have not triggered a broad monetary inflation because of the slack demand, and the consequent lack of lending and real economic growth.
And yes some well targeted stimulus could help to break this self-perpetuating situation.
And anything that does not agree with my model is a bubble, and anomaly, or someone else's fault.
The root causes of the problems in the real economy have not yet been changed, and the system has not been reformed. And the model which Paul points to is really only one correlation in a broader model that has failed, and badly, because it is an abstraction that only has a tenuous relationship with reality.
It is not so much that Paul Krugman is wrong. There are others who are much, much worse, the purveyors of austerity, and efficient market based deregulation, and supply side economics.
But Krugman is swinging open the door for the Modern Monetary Theory crowd whether he realizes it or not, by going a bridge too far in his misplaced conclusions and triumphalism. Extremism in defense of stimulus is no vice, but it is an offense to reason.
Hey, we haven't blown up the economy lately, so why worry?
Don't get me wrong. I wish Keynes was still alive, so Keynesian economics could evolve based on new data, which I am quite sure it would. In response to new data, JMK changed his mind. And I am sure he would do so again. I find myself at odds with almost every economic school because I am not an economist by training, and their dogmas and models grate on rational minds.
I liked Roosevelt, because as a non-economist he was open to trying things, but changing them if they didn't work. If he would have had a model, he would have beaten the country to death with it. That was the difference between Hoover and Roosevelt, the lack of intellectual pretension.
Well, if we only had more stimulus it would have worked. Yes that is a thought, except the system is BROKEN. The only thing we are stimulating is more money for the wealthy, more jobs for China, and more debt for the people. Yes I think there is some short term benefit for those in the most distress in some of the programs, and that is a good thing. But pouring stimulus into a broken system is only going to mask the rot, and hasten the final reckoning. I thought this is what Greenspan tried after the tech bubble collapse. And here we are again.
Better for the Fed and the economists to proceed in fear and trembling, showing their work clearly, and engaging in honest and open discussion, than risk the final, utter and total repudiation of their profession when 'trust us' fails again.
And I think it is incredibly naive to make that case that since the Fed has not blown the economy up yet, that all is well, and that printing money in whatever amounts has no significant consequences. No one believes that except a few economists who frighten me in their slavery to their models, and I would hope that you are not one of them.
Perhaps the most useful thing that Paul Krugman could do is go join Occupy Wall Street, and demand the Congress and the President take some serious action in reforming the system, because that is the only thing that is going to provide a sustainable recovery.
"Economic models are no more, or less, than potentially illuminating abstractions...The belief that models are not just useful tools but also are capable of yielding comprehensive and universal descriptions of the world has blinded its proponents to realities that have been staring them in the face. That blindness was an element in our present crisis, and conditions our still ineffectual responses.
Economists – in government agencies as well as universities – were obsessively playing Grand Theft Auto while the world around them was falling apart."
John Kay, An Essay on the State of Economics
and the associated essay of mine, The Seduction of Science in the Service of Power
Paul Krugman has been good at calling Obama and his advisors on their financial policy errors, and was roundly and unjustly criticized for it. I link to his columns frequently, because he is good at what he does, and he often speaks his mind with honest authority. And compared to many others in his profession he has been a paragon of virtue. But when it comes to their models, most economists have a fatal attraction that leads them astray.
As in all discredited professions, even if it has been due to the actions of a minority, the others must be beyond reproach, and take special care in choosing their words and their arguments. I am sorry to say that is the case with other professions now, and it is also the case with economists.
As a great economist once said, "Economics is extremely useful as a form of employment for economists." As for the rest of it, well, they have their place. They just get giddy sometimes, especially when exposed to real power, and fawn all over it.
But don't most people. They just do it with a little more humility, and with more sense of uncertainty and attention to the downsides of risk, the so-called 'black swans' that economists' models do not describe or permit, and sometimes do not even acknowledge until face meets dirt.
Obama is failing, but the alternatives are worse. Small consolation. I think the US can do better.
A great leader in a similar crisis said,
"Confidence...thrives on honesty, on honor, on the sacredness of obligations, on faithful protection and on unselfish performance. Without them it cannot live."
If most leaders in Congress and the Administration stood up and said that today, the audience would be rolling in the aisles with laughter. And if anyone from the financial sector said that, well, I would not wish to be in the radius of a lightning strike, God's work notwithstanding.
And that points to the heart of the problem. We are caught in a credibility trap, in which the leaders are so complicit in the abuse and corruption of the system that they cannot even begin to speak to it honestly and plainly, with their pockets weighted down with corporate money. And they are teaching the rest of us by their example.
October 7, 2011, 3:15 pm
Way Off Base
By Paul Krugman
I see some commenters reacting to the failure of major inflation to break out by insisting that inflation is defined as an increase in the monetary base — that is, the bank reserves plus currency that are what increases when the Fed “prints money”. As it happens, that’s wrong: very old dictionaries defined inflation as a rise in money and/or credit, but the modern usage is, of course, a rise in prices.
But that’s really a side issue. Nobody would care about the size of the monetary base except for the belief that increasing the base leads to a rise in prices. That’s not a question of definitions, it’s a question of your model of the economy. The underlying belief of all the people accusing Ben Bernanke of doing something dastardly is that “printing money” has caused or will cause high inflation in the ordinary sense.
The thing is, of course, that the past three years — the post-Lehman era during which the Fed presided over a tripling of the monetary base — have been an excellent test of that model, which has failed with flying colors. Here are the data — I’ve included commodity prices (IMF index) as well as consumer prices for the people who believe that the BLS is hiding true inflation (which it isn’t):
A couple of notes: for the commodity prices it matters which month you start, because they dropped sharply between August and September 2008. I use the IMF index for convenience– easy to download. (Thomson Reuters I use when I just want to snatch a picture from Bloomberg). But none of this should matter: when you triple the monetary base, the resulting inflation shouldn’t be something that depends on the fine details — unless the model is completely wrong.
And the model is completely wrong. You don’t get more conclusive tests than this in economics. By contrast, the model of an economy in a liquidity trap, in which big increases in the monetary base don’t matter, comes through just fine.
And this in turn tells you something about the people pushing this stuff. They had a model; it made predictions; the predictions were utterly, totally wrong; and they have just dug in further.
I do not know who 'the people pushing this stuff' are, but that last sentence applies to almost every economist and financial pundit that I can think of, with only a few notable exceptions.
A great economist would come up with something new from this, some variation on a theme, would have LEARNED something. The original thinkers are often geniuses, but their adherents are too often true believers and interpreters of doctrine. My graduate academic experience with economists of some years ago is that they lag reality, and especially the sea changes, by quite a few years, always making plans for the last war and crushing the data to fit their abstractions.
And this sadly is what may have brought the Austrian, Classical, Marxist and Keynesian schools into a type of relative stagnation, with a lack of original thought and an adherence to learned models and learned dogma. Monetarism seems to be waning as well into an American obsession with statistics, often for hire. Each of the schools have something to contribute. I have long been convinced however, that out of this new experience we are having that a new school of economic thought would rise out of the ashes. So far it is not apparent, just attempts to revive the old ideas.
Perhaps this 'digging in' is the natural reaction to a crisis. Who has the presence of mind to 'think differently.' But it is killing off the ability of the country to move forward, especially given the media's penchant for airing an issue for the public by bringing out two professional 'strategists' who throw lies and distortions and cartoon examples at one another for ten minutes, and then call it a discussion. Ok, time to vote.
No wonder the people are confused and afraid. And beginning to take to the streets. And I shudder to forecast the outcome.
By the way, Robert Reich has a nice description that touches on the credibility trap in Occupiers of Wall Street and the Democratic Party.
And Michael Hudson does a fine job describing the heart of the Occupy Wall Street phenomenon and their desire for reform and their resistance to being used and diverted as has happened to the Tea Party. As he goes into his own economic prescriptions, I obviously do not agree with all his views, but he certainly makes some interesting points.
The system is broken. It needs to be reformed. People are tired of being used and lied to. They voted for change and were ignored when they expressed their views and quite strongly. And when they complain, they are ridiculed. And now they are getting really angry. And the powers-that-be are trying to figure out how to play them for their own ends.
As Dr. Zoidberg would say, 'Wow, the President is gagging on my gas bladder. What an honor.'
"Get ready for the Pan Asian Gold Exchange, scheduled to open in June, 2012 in Kunming City, Yunman Province...Pan Asian will allow Chinese to speculate in gold futures contracts or buy physical gold through an account with a bank or broker. All 320 million customers of the giant Agricultural Bank of China will simply be able to use their Renminbi, the Chinese currency, from their bank accounts to trade gold. Sounds bloody dangerous doesn’t it.
It means the spot market in gold could be headed for China, and away from London’s Metals Exchange or the Comex in New York. I’d like to know who is going to oversee and regulate all this action. For example, when the Comex raises margin requirements to dampen speculative fervor– will China be governed by that? I doubt it very much..."
Robert Lenzner, The Chinese Mean to Control the Global Gold Market, Forbes
I assume the author, who is the national editor for Forbes, is satirizing some of the silly statements about gold recently appearing in certain other financial journals, all given by Very Serious People (VSP) who say even the most patently absurd things with self important weight, if not decorum.
About twenty years ago Steve Forbes explained his abiding fondness for the gold standard one evening over hors d' oeuvres during a break in a business conference about southeast Asia as I recall. He has promoted it several times since then including during a brief run for president many years ago, and this year predicted a return to a gold standard in the US within five years.
As you may recall I do not recommend such a rigorous standard at this time, given the debilitated nature of the US financial system. But I do think some other countries might consider giving it at least partial consideration and serious thought in their longer term currency plans, along with silver. It is one antidote, even if imperfect, against banker manipulation and financial excess.
And this is why the Anglo-American bullion bank cartel fears any discussion of gold that is not managed carefully, since certain people might get ideas. Here is a news flash for them. They already have those ideas, and you are whistling past your nearly empty vaults. A hideaway home near Lake Lucerne or vacation ranch in Paraguay may be an advisable alternative.
The charts are obviously at a decision point and they may be pushed by the headlines from Europe.
Have a pleasant weekend.
