Hera : QE3, Baltic Dry Index

Why Financial Repression Will Fail

Ron Hera — Fri, 16 Nov 2012 17:53:00 GMT

Excessive leverage and risk in the financial system, e.g., using customer funds to speculate, never ends well. Stock market crashes, bank and investment firm failures or economic recessions are all potential consequences. Following the failure of the United States to regulate over the counter (OTC) derivatives and the repeal of the Glass-Steagall Act, U.S. banks became the largest financial business entities in history. The U.S. real estate bubble, sub-prime lending and mortgage backed securities (MBS), along with unregulated OTC derivatives, then lead to bank insolvencies, a historic stock market crash and a near collapse of the global financial system.

Central banks and governments intervened to prevent systemic collapse but governments were saddled with enormous debts due to bank bailouts, lost tax revenues and massive social welfare costs. Rather than systemic collapse, and perhaps another Great Depression, the post crisis period came to be characterized by (1) market interventions, (2) direct government control over the economy, and (3) ongoing monetization by central banks. Longer term solutions that would have allowed a return to putatively free markets failed to emerge and government debt, particularly in Europe, became a crisis in its own right.

Measures that began as emergency interventions became routine suggesting a new economic paradigm. In the new paradigm, big banks, politicians and academics would decide what market outcomes, e.g., bankruptcies, interest rates or bond yields, would be permitted, as well as when to apply accounting rules, regulations and laws. Despite increased centralization of decision making and greatly expanded powers, however, policymakers were unable to repair the financial system. Instead, mounting government debt led to de facto financial repression.

Financial repression occurs when governments channel funds into their own sovereign bonds in order to reduce debt levels through mechanisms such as directed lending, caps on interest rates, capital controls, debt monetization, or by other means. Economist Carmen M. Reinhart, et al., brought the term back into popular usage in 2011 after a long hiatus. Past examples of financial repression include several South American countries, such as Argentina. The promise of financial repression is that it will hold down government borrowing costs and reduce government debt levels, but critics argue that financial repression merely targets the producers of society, i.e., the middle class, and therefore harms the economy.

The Liquidation of Government Debt , Carmen M. Reinhart and M. Belen Sbrancia (NBER 16893, 2011)

Debt monetization, which can be a tool of financial repression, destroys savings while a zero percent interest rate policy (ZIRP), which reduces government borrowing costs, deprives savers and pensioners of interest income and can lead to inflation. What is more important, however, is that financial repression prevents capital formation. Of particular concern in the U.S. is the link between capital formation and new business creation, which is primarily a middle class phenomenon. The vast majority of corporations in the U.S. are small businesses and they account for the majority of jobs. By preventing capital formation, financial repression short circuits the engine of new business creation, increases unemployment and threatens to bring down the middle class.

Governments cannot supply entrepreneurship or innovation in the marketplace, nor can they effectively replace savings (genuine capital derived from surplus production) or private investment with bank credit or with public funds, which represent debt and a transfer of wealth, respectively. The deployed capital, inventions, products and services of new businesses drive innovation, fuel competition, provide jobs and increase the wealth of society. In contrast, financial repression can only produce economic stagnation and result in a net loss of wealth to society.

Crisis and Consequence

Substantially as a consequence of the financial crisis and global recession, Europe was engulfed in a sovereign debt crisis characterized in the European periphery by austerity measures and Great Depression levels of unemployment. In the U.S., the real estate collapse and stock market crash represented a direct loss of household wealth while bank bailouts represented a transfer of wealth from proverbial Main Street to literal Wall Street. Deficit spending, debt monetization and the Federal Reserve’s purchases of MBS and U.S. Treasury bonds expressed a radically inflationary monetary policy and, although much of the money is idle in the banking system, the overall increase in the supply of U.S. dollars is concerning. The True Money Supply (TMS), formulated by famed economist Murray Rothbard, represents the amount of money in the economy that is available for immediate use in exchange.

Despite the 2008 financial crisis, global recession and inflationary policies, confidence in the U.S. dollar, the U.S. stock market, the U.S. federal government and the U.S. economy remained largely intact. Inflationary policies reduced certain risks, such as the risk of a deflationary collapse, and increased liquidity from central bank monetization lifted financial markets, but the effects were only temporary. Confidence was also boosted in Europe by the European Central Bank’s (ECB) outright monetary transactions (OMT) program and in the U.S. by the Federal Reserve’s quantitative easing III (QE3) program. In Europe, the risks of sharply rising sovereign bond yields, sovereign defaults and the potential breakup of the euro were muted by OMT while European leaders putatively moved toward a permanent solution, such as a fiscal union. Thanks in part to the Federal Reserve’s ZIRP and ongoing “operation twist,” U.S. Treasury yields remained near historic lows.

On the surface, the fallout of the 2008 financial crisis was effectively managed, but the basic causes of the crisis were never addressed. The lines between depository institutions and securities firms, erased in the U.S. by the final repeal of the Glass-Steagall Act in 1999, were not restored and the U.S. Financial Accounting Standards Board’s (FASB) mark-to-market rule was never reinstated.

Although bank capital ratios have improved, leverage remains excessive, bank balance sheet assets remain troubled and economic conditions have deteriorated compared to the pre-crisis period. Banks deemed “too big to fail” in 2008 have become bigger and the gross credit exposure associated with high risk OTC derivatives is roughly as large as it was before the financial crisis. By the end of 2013, the Federal Reserve’s balance sheet will have exceeded $3.4 trillion. At the same time, the U.S. federal government faces a so-called “fiscal cliff.”

The Road to Stagflation

For 2012, the International Monetary Fund (IMF) projects GDP 2.2% growth in Japan and the U.S. and 3.5% globally. Based on the Baltic Dry Index (BDI), which reflects the price of moving major raw materials by sea, the global economy has slowed in 2012. Nonetheless, there has been some improvement in comparison to the depths of the global recession in 2009.

The BDI is a leading indicator of economic growth because it reflects the demand of manufacturers for raw materials. A decline in the BDI signals falling global demand for manufactured goods. In the U.S., rail carloads also indicate falling demand.

In contrast, removing potentially optimistic projections, the U.S. Energy Information Administration’s (EIA) liquid fuels consumption data suggests an anemic recovery in the U.S. on a par with 2011.

Despite the recent uptick in U.S. manufacturing, manufacturing currently accounts for only 11.7% of U.S. GDP. In the past few decades, U.S. corporations moved production offshore, eliminating domestic jobs. Credit expansion masked the lost income of U.S. consumers but the process inexorably reached its logical conclusion in 2007. The shift of U.S. workers to often lower paying service sector jobs was counterproductive because debt levels rose while income flowed out of the U.S. following on the heels of jobs.

Although policymakers, including Federal Reserve Chairman Ben Bernanke, deny it, in fact, U.S. unemployment is a long term, structural problem linked to the still ongoing outflow of U.S. consumer incomes to net exporter countries such as India and China.

The current surplus of U.S. labor, abundant capital and somewhat less expensive energy (partly due to advances in hydraulic fracturing that have increased U.S. domestic oil production) are insufficient to stimulate a broad-based economic recovery. In addition to the U.S. federal government’s growing debt and need for increased tax revenues, U.S. consumers remain burdened with high debt levels.

A U.S. manufacturing renaissance, for example, is unlikely to take hold unless the U.S. dollar weakens significantly and global demand also rises. In a global slowdown it remains unclear where new customers might come from for new U.S. products or services.

Although the financial system has continued to function due to massive infusions of liquidity, economic activity, with some exceptions, has not generally recovered or has continued to deteriorate, e.g., the shrinking number of U.S. citizens participating in the official workforce. Ignoring improvements in the unemployment rate related to the shrinking size of the workforce, much of the U.S. economic recovery in the post crisis period can be attributed to government deficit spending.

U.S. GDP has been boosted by government deficit spending in excess of $1 trillion per year. Removing the temporary effects of extraordinary deficits, U.S. GDP remains negative. Compounding the problem, loose monetary policies, rather than spurring lending to consumers or small businesses, have created inflationary pressures and have lead to stagflation.

Rather than putting Americans back to work, inflationary policies have helped to push prices higher. Based on U.S. Consumer Price Index (CPI), the official inflation rate in the U.S. is roughly 2%, but the CPI does not accurately measure the cost of maintaining a constant standard of living. Using the same methodology as in 1980, the CPI should be 9.3% currently.

Inflationary central bank policies support government borrowing and the banking system but increased liquidity resulting from low interest rates, central bank asset purchases or debt monetization can have destabilizing effects. Excess liquidity can result in price inflation, fuel financial speculation or asset price bubbles, or provoke competitive devaluations (currency wars). Asset purchases and debt monetization by central banks alter the distribution of money, thus of purchasing power over the economy and therefore redistribute wealth. Monetary inflation erodes the value of savings replacing genuine capital distributed throughout the economy with credit concentrated in banks. In the U.S., one of the Federal Reserve’s policy assumptions is that asset purchases will help small businesses by making more credit available. While it is true that small businesses rely on bank credit for operations and expansion, it is savings, not credit that fuels small business creation and therefore job growth. Since most U.S. jobs are in small businesses, QE3 and similar policies destroy jobs by redistributing wealth from savers, entrepreneurs and investors to banks and stifling new business creation. The combination of reduced new business creation, continuing high unemployment and inflationary price pressures set against a backdrop of high debt levels precisely defines stagflation.

Reign of Repression

The stagflationary environment in the U.S. is a mild example of financial repression. Countries in the European periphery, e.g., Greece, Italy, Spain, Portugal and Ireland, where high taxes and austerity measures are already in place, are more pointed examples. In the case of Greece, which has descended into an economic depression, the natural market outcome would have been a Greek default and an exit from the European Monetary Union (EMU) accompanied by losses for European banks and quite probably a number of European bank failures, along with the systemic impact of associated OTC derivatives, such as Credit Default Swaps (CDS). To prevent bank losses and failures, however, policy decisions replaced market outcomes. The normalization of market interventions, direct government control over the economy and ongoing monetization by central banks represented a transition from a market based status quo to a policy based status quo which maintained or increased otherwise unworkable government debt levels. Maintaining the status quo, however, requires financial repression.

Like the emergency measures that preceded it, financial repression has become a fixture in a new economic paradigm, but it is no more likely to provide a permanent solution. Financial repression will remain in place as long as bank failures and sovereign defaults continue to be prevented, e.g., through bailouts, asset purchases or debt monetization by central banks. Overall economic conditions in Western countries can therefore be expected to remain stagnant or to deteriorate. The continued debasement of major currencies, such as the U.S. dollar and the euro, will reduce the real value of debts but monetary inflation cannot create a genuine economic recovery as long as bank balance sheets and government finances remain impaired. Without robust economic growth, however, both the banking system and the finances of Western governments certainly will remain impaired. In other words, financial repression in the U.S. and in Europe is set to remain in place indefinitely.

Under an ongoing regime of financial repression, savings, jobs, economic opportunity and living standards will all suffer. The middle class will be reduced as generations of socioeconomic progress are gradually reversed. Younger people, mired in stagflation, will be left behind in terms of income and economic opportunity, which will have a long term negative impact. Since U.S. banks stand to profit from financial repression, it will increase income disparity and the concentration of wealth. The destructive forces set in motion by financial repression will greatly increase the burden on government social welfare programs. Thus, financial repression will fail to alleviate government debt unless tax increases and austerity measures follow, which could turn the United States into another Greece. In theory, financial repression, together with other measures, can liquidate government debt but, in practice, it is a destructive and highly destabilizing approach that will result in a net loss of wealth to society.

Financial Crime Is A Systemic Risk

Ron Hera — Tue, 23 Oct 2012 11:38:00 GMT

Famed Austrian economist Ludwig von Mises wrote in his seminal work, Human Action (originally published by the Yale University Press in 1949), that “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” The collapse of a historic credit bubble occurred in 2008. However, despite years of further credit expansion, “a final and total catastrophe” of the U.S. dollar system has yet to occur.

While an inflationary U.S. monetary policy has serious consequences, hyperinflation is not an immediate result. There are three general ways in which the U.S. dollar system could break down: (1) rejection of the U.S. dollar as the world reserve currency, or (2) as an eventual consequence of U.S. federal government insolvency and (3) a domestic failure of confidence. Of the three, U.S. federal government insolvency is the most serious because it would result in both the loss of the U.S. dollar’s world reserve currency status and also in a failure of domestic confidence. However, a new threat to the U.S. dollar has emerged which could trigger a hyperinflationary collapse before the U.S. federal government’s finances become unworkable, e.g., when debt service begins to crowd out military and Social Security spending. Specifically, the perceived legitimacy of the U.S. financial system has not merely been tarnished by recent scandals but is in danger of collapsing. The consequences of a domestic breakdown of confidence and trust in the U.S. financial system cannot be overstated.

World Reserve Currency Status

The most commonly cited challenge to the U.S. dollar system relates to its waning status as the world reserve currency. The BRIC countries (Brazil, Russia, India and China), along with South Africa, no longer use the U.S. dollar for trade settlement amongst one another. The Chinese have internationalized the renminbi (RMB), which is now used in trade settlement with the other BRIC countries, as well as with Australia, Japan, the United Arab Emirates (UAE), Iran and various South American and African countries under bilateral agreements. Iran, which is the world’s 4th largest oil exporter, has refused to accept U.S. dollars in exchange for crude oil since 2009. While European countries utilize the euro, South American countries have instituted a local currency payment system, the Sistema de Pagamentos em Moeda Local or SML. At the same time, the IMF stands ready to settle international trade using Special Drawing Rights (SDRs). However, local settlement at the regional level is largely irrelevant.

At the global level, the implicit crude oil backing of the U.S. dollar by the Organization of the Petroleum Exporting Countries (OPEC) remains in place and the U.S. military remains dominant. As long as OPEC backs the U.S. dollar, and as long as there is no viable challenger, the U.S. dollar is unlikely to be deposed. The euro, for example, is a troubled currency and its future is questionable. China’s economic ascent is likely to continue and the RMB can be redeemed for Chinese-manufactured goods. However, the Chinese economy is currently in a recession, the RMB is not a fully international currency and China’s military is not ready to take on the role of a global superpower.

At present, no national currency stands as a viable challenger for the position held by the U.S. dollar and there is no consensus regarding its eventual replacement. However, discussion of the gold standard has moved from the fringes of the financial world into the mainstream. The price of gold has risen in response to widespread currency debasement, i.e., as a hedge against inflation.

OPEC and many other countries could, potentially, fall back to gold if the U.S. dollar were no longer viable, i.e., if the prices of global commodities, and especially the price of gold, were to rise at an accelerating rate measured in U.S. dollars. China and Russia, for example, are significant buyers of gold and crude oil can be purchased with gold instead of U.S. dollars pursuant to bilateral agreements, if not on world markets generally. An eventual return to the gold standard is possible but seems unlikely in the near term.

Governments, banks and corporations around the world hold trillions of U.S. dollars along with U.S. dollar denominated financial assets, such as U.S. stocks and U.S. Treasury bonds. Even countries hostile to the United States cannot benefit by refusing U.S. dollar transactions or by dumping U.S. Treasury bond holdings in the market. Ignoring the fact that the Federal Reserve and its Primary Dealers, together with other Western central banks, stand ready to intervene as needed to support the U.S. dollar, retaining the majority of the value of U.S. dollar holdings is always a superior alternative in the short run, particularly if the alternatives are economic sanctions, war, or, in the case of the U.S. dollar’s collapse, a 100% loss.

In other words, the tolerance of the world financial system and of the global economy for the U.S. zero percent interest rate policy (ZIRP), ongoing U.S. Treasury bond market interventions, i.e., Operation Twist, and quantitative easing is far greater than is commonly believed. The U.S. dollar certainly will be replaced as the world reserve currency at some point in the future, but claims that the U.S. dollar is in danger of imminent collapse as a result of international rejection are exaggerated.

U.S. Federal Government Debt and Unfunded Liabilities

Setting aside the world reserve currency status of the U.S. dollar, the largest threat lies in the risk of U.S. federal government insolvency. Before the 2008 financial crisis, the U.S. federal government had reached a point where no combination of economic growth, tax increases or government budget cuts will allow it to pay back its public debt and also meet its unfunded liabilities.

As a percentage of GDP, total U.S. federal government debt is larger than that of Spain and nearly as large as that of Portugal and Ireland.

The U.S. federal government’s budget deficit, which stands at approximately 8.7% of U.S. GDP, is as high as that of Greece and higher than those of Spain, Portugal and Italy.

Total U.S. government spending at all levels is approximately 40% of GDP and, unless economic conditions improve, will increase further. Unfunded liabilities of the U.S. federal government total $61.6 trillion ($534,000 per household). The liabilities include federal debt ($9.4 trillion) and obligations for Medicare ($24.8 trillion), Social Security ($21.4 trillion), military retirement and disability benefits ($3.6 trillion), federal employee retirement benefits ($2 trillion) as well as state and local government obligations ($5.2 trillion). Based on Generally Accepted Accounting Principles (GAAP), economist John Williams has projected U.S. federal government insolvency and, as a result, hyperinflation, as soon as 2014. Mr. Williams’ projections do not include the fact that numerous U.S. states, counties and cities are insolvent or at risk for bankruptcy.

The insolvency of a sovereign nation becomes inevitable once new borrowing is required to service existing debt, but the Minsky moment only arrives when (1) further borrowing becomes impossible and also when (2) monetization results in rejection of the currency. The more unworkable U.S. federal government finances become, the more likely a hyperinflationary collapse of the U.S. dollar will become. Increases in the money supply and in debt levels suggest that the probability of a hyperinflationary collapse of the U.S. dollar is increasing at an accelerating rate.

An inevitable outcome is not necessarily an immediate one and U.S. policymakers are masters of “kicking the can down the road.” Another financial crisis or a further economic decline in the U.S. could accelerate the financial breakdown of the U.S. federal government, but a robust U.S. economic recovery, technological breakthroughs and other decelerating factors could delay it.

Despite the fact that Mr. Williams’ Hyperinflation Special Report 2012 is required reading, the timing of the predicted outcome assumes a low international tolerance for the monetization of U.S. federal government debt. Mr. Williams implicitly assumes that the market for U.S. treasuries is a free market and that, therefore, either U.S. Treasury bond yields will skyrocket or that willingness to lend to the U.S. will collapse, but that may not be the case. Together with other central banks, the Federal Reserve could continue to manipulate U.S. Treasury bond yields and the value of the U.S. dollar for an indefinite period of time. On one hand, according to Herbert Stein’s Law, “If something cannot go on forever, it will stop.” On the other hand, the U.S. dollar remains ‘the worst currency in the world, except for all the rest.’

Since the start of the Federal Reserve System, the U.S. dollar has passed one apparent ‘point of no return’ after another and with each one, e.g., the start of QE3, critics have argued that the collapse of the U.S. dollar is imminent. The roots of the arguments generally date back to 1971 when Nixon closed the gold window. Severing the link to gold was a crucial point of no return, but, more than forty years later, a hyperinflationary collapse of the U.S. dollar has yet to occur. If history is any guide, additional points of no return lie ahead for the U.S. dollar.

Domestic Confidence in the U.S. Dollar

Within the United States, outside of Wall Street and Washington D.C., the overall economic environment in the broad U.S. economy remains deflationary. Bank lending to consumers and small businesses remains depressed while debt service represents steady deflationary pressure. In other words, private sector debt levels remain high and money is relatively scarce in the ‘real economy’. Reported increases in consumer credit are significantly the result of increased student loans, which are linked to unemployment and poor job prospects for young people.

A scarcity of physical notes or a race to shed currency in favor of hard assets seems unlikely to originate within the U.S. unless there is first a conspicuous scarcity of goods. Virtually unlimited support for banks by the U.S. federal government and by the Federal Reserve has thus far proven sufficient to prevent a panic. U.S. households do not generally have cash and often rely on electronic conveniences, such as automated payroll deposits, electronic bill payment and on credit and debit cards. Additionally, unlike countries that have suffered hyperinflation in recent history, U.S. citizens have no practical alternative currency. In the absence of runaway inflation, the impetus to flee the banking system or to rush out of the U.S. dollar is unlikely to originate in a domestic collapse of confidence regardless of U.S. monetary policy.

An outlying but growing problem is the risk of a breakdown of confidence and trust in the U.S. financial system related to its perceived legitimacy. Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement pose a serious threat to the U.S. dollar system.

Before the 2008 financial crisis, confidence in the U.S. financial system was shaken by fraudulent sub-prime mortgage lending and securitization practices. The collapse of the housing bubble and the 2008 financial crisis revealed profound systemic risks. In 2010, the so-called “Flash Crash” reopened questions about the stability of U.S. financial markets and, in 2011 “robo-signing” and other foreclosure frauds were reminiscent of sub-prime lending.

In late 2011 and 2012 perception of the U.S. financial system suffered a staccato of blows, including the failure of MF Global Holdings Ltd., with the loss of $1.6 billion in customer funds; JPMorgan Chase & Co.’s $6.2 billion “London Whale” OTC derivatives trading loss; the failure of Peregrine Financial Group Inc. (PFGBest), with the loss of over $200 million in customer funds; money laundering by HSBC for drug cartels, including Mexico’s most violent criminal organization, Los Zetas, and for states that sponsor terrorist organizations; Knight Capital Group Inc.’s high-frequency trading (HFT) loss of $440 million; as well as a growing number of civil and criminal cases linked to mortgage, foreclosure and securities fraud.

Scandals elsewhere in the world, such as the rigging of the London Interbank Offered Rate (LIBOR) by Barclays, in cooperation with other banks, including JPMorgan Chase & Co. and Citigroup, Inc. in the U.S., further undermine confidence in the U.S. financial system.

A Black Swan?

Recklessness, criminality, out-of-control automated trading systems (ATS) and apparent failures of regulation and law enforcement could trigger a hyperinflationary collapse. The result of a domestic breakdown of confidence and trust in the U.S. financial system would not be a traditional run on banks or a rush into cash due to mistrust of banks (creating demand for physical notes) or a rush out of dollars into hard goods due to runaway inflation but rather a run on financial markets. If investors, pensioners, private institutions and fund managers withdraw from the markets in order to preserve their capital, it could potentially cause not merely a stock market decline but a crash. In the worst case, a domestic breakdown of confidence and trust could lead to a near total collapse of U.S. financial markets. The failure of financial firms, the accelerated disintegration of the U.S. dollar’s world reserve currency status and the final bust of the U.S. government’s finances would follow. Neither the federal government nor the Federal Reserve can fix the U.S. financial system if its perceived legitimacy were to fail. An inflationary policy response, at that point, would only exacerbate the problems of the U.S. dollar. History may record yet again that “there is no means of avoiding the final collapse of a boom brought about by credit expansion” because the escalating moral hazard engendered by limitless bailouts is itself a cause of collapse.