Immoral Hazard

Out along the edges
Always where I burn to be
The further on the edge
The hotter the intensity
--Kenny Loggins

Warren Buffett proposes that the 'solution' to excessive risk taking by bank execs is to excessively penalize these execs in the event of big losses. Shareholders didn't cause the recent meldowns, he suggests, but they have bourne the brunt of the losses.

Shareholders had no role in the meltdowns? They bid up share prices of highly leveraged firms, and voted in top execs, the boards, and lavish pay/incentive structures.

The way markets are supposed to work is that firms that make bad decisions get penalized. If the decisions are poor enough, then the firm goes away and someone else takes control of the resources who looks to be able to do a better job.

What role do shareholders have good decision-making? They can look at the level of risk on a firm's balance sheet and don't buy (or sell) shares of firms that have excessive leverage. Extreme leverage was visible to anyone willing to look prior to the meltdown. The argument can easily be made that shareholders, like managers, were willing making leveraged bets on a risky strategy that went awry.

Shareholders can also walk away from firms that have undesirable incentive structures.

Warren Buffett seeks to bake additional moral hazard into a system that already has millions of players thinking that someone has their back.

In properly functioning markets, shareholder they take responsibility for their role and bear the consequences their decisions.

Filing Claims

Wyatt Donnelly: "Do you think Lisa's having a good time?"
Gary Wallace: "Lisa could have a good time at an insurance seminar, Wyatt."
--Weird Science

Just chewed thru the Berkshire Hathaway annual letter to shareholders posted this am. One of the least interesting letters I can remember.

The one comment that did catch my eye was on the bottom of p. 4 where Warren Buffett claims that Berkshire was not a beneficiary of the government bailout that transpired over the past yr and a half. One snippet:

"When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant."

This commentary seems disingenuine to me. The leveraged financial entity that is Berkshire surely was, and continues to be, a net beneficiary of government stimulus.

I'd submit that Berkshire Hathaway is highly dependent on government's ongoing interventionary policies and inflationary bias.

no positions

Sickly Symptoms

Here comes the rain again
Raining in my head like a tragedy
Tearing me apart like a new emotion
--Eurythmics

Markets are moving much more on news related to government intervention than on business fundamentals. Interest rate policy, sovereign debt defaults and bailouts, rule changes on short selling, government assistance programs--developments here dominate the price action.

How healthy can finanical markets be when markets depend on the extent of interventionary measures?

Seems more a an addiction/dependence relationship to me.

Class Action

You tell me it's the institution
Well you know
You better free your mind instead
--The Beatles

Just chewed thru Marx and Engel's (1848) Communist Manifesto. Officially the title translates as Manifest of the Communist Party, and was first published in London in 1848 by a group of German refugees.

This reads more like a political pamphlet than a well reasoned book. It proposes a world of class conflict, where workers struggle and gradually lose against oppressive capitalists. And that workers should use their majority weight to overthrow the capitalist system and replace it, ultimately, with a single class rule where all property is publicly rather than privately owned.

On the surface, one can see why this publication makes lovers of liberty nervous. It reflects an explicit call-to-arms against individual freedom.

But just because there's a bully on the playground threatening to beat you up doesn't mean you must pre-emptively attack. All the same, Sun Tsu would certainly advise knowing, and maintaining acute awareness of, your potential enemy.

One would think that this book would appeal to those interested in upping their standard of living by political rather than economic means. And the class conflict construct of Marx and Engels apparently is enough to whip some people into an emotional frenzy of compliance.

The irony is that the core thesis, that a class-less state where property is publicly owned and operated will produce a higher standard of living, is terminally, and almost laughably, flawed from an economic standpoint. We have been treating this point, and will continue to treat it, in other missives.

Dismissing the threat on rational grounds, however, would be a mistake. The socialist proposition seems to be aimed at the brain's limbic system. The limbic system houses emotional rather than rational process, and is ground zero for the herding impulses that drive such phenomena as mob rule.

Perhaps the most useful portion of the Manifesto is the 10 point playbook suggested by Marx and Engels for gradually overthrowing a free society:

1) Abolish private land ownership
2) Institute a progressive income tax
3) Abolish the right to inheritance
4) Confiscate property of all emigrants and rebels
5) Centralize credit and banking in the hands of the State
6) Centralize means of communication and transportation in the hands of the State
7) Increase State ownership of factories and means of production
8) Establish industrial armies (read unions)
9) Distribute population more evenly between town and country
10) Educate children in public schools

It is undeniable that at least some items from this list are in motion today.

After a lengthy slumber, perhaps some folks are waking up to this reality.

Reference

Marx, K.H. & Engels, F. 1848. Manifest of the Communisty Party. London: Burghard.

Trampled Underfoot

"Here's to the men who did what was considered wrong, to do what they knew was right...what they knew was right."
--Benjamin Franklin Gates (National Treasure)

Sage economist Walt Williams discusses the expansion of government beyond its intended role as per the Constitution.

Professor Williams provides some nice quotes from Presidents Madison, Cleveland, and Pierce who vetoed spending bills because they were not within the scope of the Constitution.

He also discusses the 'General Welfare' clause--the oft used 'loophole' evoked by bureaucrats over the past 100 yrs to expand government beyond Constitutional boundaries. He provides some fantastic quotes from Founders who wanted to put this clause in its proper place:

Madison: "If Congress can do whatever in their general discretion can be done with money, and will promote the General Welfare, the Government is no longer a limited one, possessing enumerated powers, but an indefinite one subject to particular exemptions."

Madison II: "With respect to the two words 'general welfare,' I have always regarded them as qualified by the detail of powers connected with them. To take them in a literal and unlimited sense would be a metamorphosis of the Constitution into a character which there is a host of proofs was not contemplated by its creators."

Jefferson: "Congress has not unlimited powers to provide for the general welfare, but only those specifically enumerated."

Over the past century, we have thrown these intentions out the window.

I'm confident that, if the Founders were able to hold a press conference right now, they'd opine that the greatest challenge facing the United States is marshalling to the fortitude to reverse course back toward the country's original design of limited government and liberty.

Betwixt and Between

"It is well known that the more a man speaks, the less he's understood."
--Abraham Lincoln (The Blue and the Gray)

The are two 'pure' ways of economic organization. One is capitalism, also known as a market economy. A capitalistic economy is a form of social cooperation based private ownership of the means of production. Decisions about what to produce and how to distribute output rest in private hands. In a market economy, the state's role is limited to the protection of property of its citizens against force or fraud.

The other alternative is socialism, also known as as state capitalism or authoritarian economy. A socialistic economy is a form of social cooperation based on public ownership of the means of production. Production and distribution decisions rest in government hands. In a socialistic economy, the state's scope is virtually unlimited.

Most would agree that, as defined, both of these economic forms are currrently more theoretical than practical. That is to say that neither of these pure forms exist in today's world on a sovereign scale. Instead, all national economies operate somewhere between the two extremes.

Mises (1998) referred to this middle ground as interventionism, also known as managed capitalism or hampered market economy. In an intervenionist economy, markets still exist, but the state seeks to interfere with behavior by use of coercive power, usally expressed through restrictive measures or price controls.

Visualize a grid that looks something like this:

|capitalism<-------------------------------->socialism|

Depending on the degree of intervention, you could plot any economy somewhere on this continuum.

A unidimensional scale might be the extent to which the economy is managed by the state:

|0% managed<---------------------->100% managed|

The most pressing issue on my mind (ouch) concerns the dynamics associated with the interventionist condition, i.e., can interventionist economy operate at a single point on the grid? Or is there a 'gravitational pull' that tugs an economy to one of the extremes over time? My reading thus far suggests a theoretical bias toward interventionism migrating toward socialism (Hayek, 1944; Marx, 1867; Schumpeter, 1942).

However, I wonder whether alternative cases are reasonable. Hope to explore these in future work.

Reference

Hayek, F. 1944. The road to serfdom. Chicago: The University of Chicago.

Marx, K. 1867. Das kapital, Vol. 1. Hamburg: O. Meissner.

Mises, L. 1998. Interventionism: An economic analysis. Irving-on-the-Hudson, NY: The Foundation for Economic Education, Inc.

Schumpeter, J.A. 1942. Capitalism, socialism, and democracy. New York: Harper & Brothers.

Review Form

You can say anything you like
But you can't touch the merchanidise
--The Tubes

Schumpeter's (1942) argument concerning the destruction of capitalism was outlined previously. While his theory has some appeal, there is much to contest. Let me humbly submit a few issues that I see with his argument.

Much of Schumpeter's argument depends on the presence, and persistence, of large firms that wear down capitalism by their rationalization efforts. Drives to improve efficiency, he argues, serve to standardize entrepreneurial processes, thus marginalizing capitalistic function. Scale also crowds out small firm proprietors thought by Schumpeter to be primary champions of property rights and free contracting. Such a proposition seems to contradict the very essence of the 'creative destruction' concept of capitalism that Schumpeter previously (and famously) emphasizes at great lengths. In free markets, it is difficult for large firms to persist. Opportunities evolve which favor new entrants over incumbants. As long as entry is not impeded (in which case we would not be talking about a truly free market system), then marginalization of capitalism by large firms seems unlikely in the long run. If capitalism is truly a process of creative destruction, then how can/do barriers that squelch this process come to exist?

Schumpeter posited that capitalism destroys many of the feudal institutions (e.g., villages, craft guilds, etc) that historically served to protect the capitalist class. The question here is why such institutional protection is necessary. If government was properly limited in scope to be the protectors of property rights (which is a necessary condition for capitalistic systems), then there is no need to fall back on socially-oriented mechanisms that were necessary when plunder was facilitated the state. Similar to the previous proposition, Schumpeter seems circular in his reasoning here (i.e., markets can't stay free because the mechanisms that support free markets are not in place--which bids the question how markets were ever free in the first place...).

Schumpeter argued that shareholders of large firms, and their managers, would decry private property and free contracting. It is difficult for me to comprehend how this could be. Shareholders, as owners, are likely to pursue firm grasp on their property and contracting rights. As for managers, Schumpeter seems to be evoking some variant of agency theory to suggest that managers have no perceived stake in the company thus they behave in an interested fashion. But large firm managers have personal property to protect--if not at their firms then at home. Moreover, these managers would surely want to preserve their freedom to contract in the market for talent. Schumpeter's arguments here are neither intuitive or convincing.

I do think Schumpeter scores with his argument about the intellectuals and their critical bent against capitlism. His propositions seems to garner a decent amount of support today via empirical observation. However, the effectiveness of anti-capitalist intellectuals depends on capacity of citizens to think critically themselves. An engaged citizenry would render propaganda efforts ineffective.

Assuming, for sake of argument, that all of Schumpeter's points are valid, the question remains whether these factors would be enough to drive capitalism to a socialist endgame. Schumpeter definitively says 'yes,' and Part III of his book provides rationale for why this should happen. Once again, I found his arguments unconvincing.

The obstacle that Schumpeter cannot convincingly overcome is how a system moving toward socialism compensates for the disappearance of a pricing system that in capitalistic systems serves to effectively allocate resources. Primarily, planners cannot easily make economic calculation (market prices don't exist), and bureaucratic processes are slow to adapt to a changing world, which ultimately renders central planning ineffective in resource allocation. Schumpeter's arguments do not pursuade otherwise. Because economic resources are likely to be misallocated, standard of living in a socialistic system is bound to be inferior. Morever, once enough people experience squalor, then further movement toward socialism is likely to be politically difficult.

We've experienced examples of this since Schumpeter's passing--the sad economic state of the Soviet Union upon its collapse being the highest profile flameout. In fact, a case may be made that burgeoning debt levels we currently observe worldwide are consequences of modern socialization efforts. One has to wonder whether borrowing from the future is merely a natural reaction by bureaucrats seeking to make socialistic systems 'work' today in the eyes of their citizens.

Such an illusion, of course, is not durable.

One more thought. Were I Schumpeter, I would have done more to elaborate conditions under which capitalism might convert to socialism. It is reasonable to believe that some contexts may be more or less friendly than others. It strikes me, for instance, that conditions of extreme environmental stability and certainty would be almost a necessity for socialist planners to have even a snowball's chance in **** of succeeding. Such conditions, of course, are in short supply today.

Path dependence might also matter. For example, a country that was founded on the principles of individual liberty and small government, such as the United States, would seem a more difficult hurdle for the capitalism->socialism progression than a country grounded in a history of despotism.

Reference

Schumpeter, J.A. 1942. Capitalism, socialism, and democracy. New York: Harper & Brothers.

Capital Loss

You say you'll change the constitution
Well, you know
We all want to change your head
--The Beatles

Just completed Schumpeter (1942). Back in my grad school days, I read selections from this book--primarily to become familiar with Schumpeter's infamous 'creative destruction' concept of the capitalistic process.

As I'm presently engaged in acquiring a better understanding of socialism vis a vis capitalism, Schumpeter's (1942) work is interesting because he theorizes that capitalism as an economic and social system lacks durability and inevitably falls to socialism. Unlike Marx (1867), however, who posited that capitalism would be appropriated by socialist revolutionaries as a consequence of increasing class conflict, Schumpeter theorized that capitalism would transition more gradually into socialism as a number of factors peculiar to capitalism evolved.

The gist of his argument appears in Part II of the book and is entitled Can Capitalism Survive? In Chapter 12 entitled Crumbling Walls Schumpeter elaborates four factors that he posits will destroy capitalism over time:

1) The ceasing or standardization of capitalistic 'progress' which destroys incentive for entrepreneurial initiative. In particular, large scale operators, thru methods that promote rationalization (i.e., efficiency), serve to squelch the entrepreneurial (i.e., 'bourgeoisie') function.

2) Capitalism destroys institutional arrangements of the feudal world (e.g., the village, craft guilds, charismatic rulers) that historically offered protective cover to (not from) capitalists. Absence of this cover leaves the bourgeousie vulnerable to attack from other groups.

3) As scale of capitalistic enterprise grows, loss of small and medium sized firms leads to loss of respect for private property and free contracting--two anchors of free markets. Schumpeter posits that small business owner/managers typically champion these free market elements more than managers or shareholders of big business. As this class of champions disappears, private property and free contracting are more prone to be contested. Capitalism is rendered politically defenseless.

4) Insecurity from the 'creative destruction' process of capitalism breeds social unrest. Intellectuals, people who wield power of the written and spoken word but who have little direct responsibility for practical affairs, are primary instigators of this unrest. Intellectuals are motivated to rail against capitalism because, paradoxically, increased standards of living prompt more folks toward advanced education. Schumpeter suggests that supply of highly educated individuals is likely to exceed demand at some point, leaving a large group of underemployed intellectuals bitter and critical of capitalism--in fact, such criticism may provide a livelihood for the critics! Because, according to Schumpeter, most people are prone to blindly accept what others say rather than to think for themselves, a great many will fall in to the anti-capitalist creed. Two special interest groups particularly likely to be amenable to the intellectuals' siren song are labor and politicians.

In a speech just before his death in 1949, Schumpeter expressed confidence that these drivers were in motion and capitalistic systems worldwide were still marching toward socialism, although he thought that many observers were in denial of such a transition. In particular he observed the presence of government interventions in many markets, including the United States that, in his view, would have been unthinkable a few decades earlier. He also proposed that war and inflation were two vehicles that could accelerate movement toward socialism, as resulting bureaucracies wrap capitalism in an irreversible choke hold.

There is much here to contest, and many have (as will I in future posts). At the same time, however, one cannot marshall a huge batch of empirical evidence today to decisely refute Schumpeter's (1942) theory on 'real world' grounds. Indeed, objective observation might suggest that, in many ways, his theory is on track.

References

Marx, K. 1867. Das kapital, Vol. 1. Hamburg: O. Meissner.

Schumpeter, J.A. 1942. Capitalism, socialism, and democracy. New York: Harper & Brothers.

Credit/No Credit

We can dance if we want to
We've got all your life and mine
As long as we abuse it
Never gonna loose it
Everything will work out right
--Men Without Hats

Mike Shedlock shares some charts on interest rates and credit over the past few decades. One of them is pasted below.

As Mish notes, many folks are concerned about the 'huge' drop in bank credit during this recession. But it almost requires highlighting (the red circle) in order to offset it from the main feature of this chart: the parabolic run up in credit during the previous 20+ yrs.

It is interesting that this is the first decline in bank credit since the 1970s. Moreover, returning to 'trend' as reflected by the red lines on the chart suggests quite a bit more credit needs to be wrung out of the system.

Despite Fed and other bureaucratic efforts to the contrary, market forces are seeking to reverse the credit/debt extreme.

Truth or Consequences

So true, funny as it seems
Always in time, but never in line with dreams
--Spandau Ballet

Any economic/social system must cope with a handful of truisms.

Diversity. People are unique in their skills, taste preferences, cognitive abilities.

Bounded rationality. While the upper bound differs among individuals, people are limited in their cognitive abilities. The more complex the situation, the more difficult sensemaking and decision-making becomes.

Self-interest. People make self-interested decisions. This does not necessarily mean that decisions are 'material' or 'selfish.' Altruism and other non-material motives drive self-interested behavior as well.

Diminishing marginal utility. The more units of a commodity that an individual consumes, the lower the satisfaction per unit.

Resource scarcity. Resources are scarce, necessitating the need to 'economize' them.

There may be others, and will add as they come to mind.

The important thing to note is that these items are uncontestable. Any economic/social system needs to deal with these realities.

Capital Gains

"Jack dreams that he can hustle the American working man, who's one dream is that he could be rich enough not to work, into a revolution led by his party."
--Eugene O'Neill (Reds)

As Mises (1951) observes, opponents of capitalism often argue that social welfare is not the goal of self-interested capitalists. What socialists miss, however, is that by individuals making economic calculations grounded in their own self-interest, efficiency improves and innovation thrives.

Socialist systems, on the other hand, are incapable of economic calculation. Prices do not exist to provide the basis for calculation. And planners cannot grasp the complexity of long production systems, nor the dynamic taste preferences of consumers. Efficiency declines. Improvement stagnates.

A great paradox (or is it the irony?) of capitalism is that thru self-interested decisions of individuals, social welfare improves beyond the capacity of socialist systems.

References

Mises, L. 1951. Socialism: An economic and sociological analysis. New Haven: Yale University Press.

Surprise Surprise

"What do you want from me? I'm just a word processor."
--Paul Hackett (After Hours)

Surprise of the day is the Fed's 25 bip increase in the discount rate after the markets closed this pm. Am sure this will be talked to high heaven as to its 'real' meaning, but an untelegraphed tightening by the Fed, even a measly quarter point raise, has to serve as at least a minor gut check to the 'printing press' crowd.

Revise and Resubmit

And the world looks just the same and history ain't changed
'Cause the banners they are flown in the next war
--The Who

I had always regarded 'revisionist history' to mean attempts to alter 'true' accounts of history to something more tainted and biased. A bad thing.

Articles such as this one indicate that I've gotten it completely backwards.

Historical revisionism reflects efforts to add important perspectives that, for accidental or intentional reasons, have been previously omitted from historical accounts.

As the author of the article notes, there can be quite a pushback from those who desire that historical accounts remain biased, narrow, and/or perhaps even false.

My humble forays into US history suggest that, in addition to the WWI and WWII periods the author mentions, other periods that could stand more revisionist attention include FDR and the Great Depression, the 'progressive period' of the late 1800s and early 1900s (which founded, among others things, institutions such as the Fed and the Sixteenth Amendmentment), Lincoln and the origins of the Civil War, and the country's climate surrounding the development and ratification of the Constitution.

Historical revisionism should be welcome to anyone who values critical thinking.

Speaking Too Soon

Nothing is planned
By the sea and the sand
--The Who

From the deck of an aircraft carreir a few weeks after the Iraqi War commenced, President Bush famously proclaimed the battle over. We're still at it seven yrs later.

Today, from his perch one year after the first massive stimulus bill was enacted, President Obama proclaimed that a Second Great Depression has been averted and jobs have been saved.

History, of course, has yet to gauge how premature Mr Obama's remarks are.

Inquiring minds should be asking how a massive spending and debt program solves a spending and debt problem. Rather than averting a crisis, it seems highly probable that such actions extend the period of economic malaise, and intensify the decline that will occur when government intervention is no longer capable of temporarily stemming the tide.

The Victim Dictum

Some people never come clean
I think you know what I mean
--Eagles

I frequently read or hear that a certain individual or group of individuals has been 'used' by another individual or group.

In most cases, claims of being an innocent victim seem inaccurate. A distinguishing feature of humans is self-awareness. As individuals we have capacity for sensing our environment and the external forces that act on us. We then can choose to counter those forces or to 'go with the flow.'

It might be argued that some individuals' capacity for sensing environmental forces may be under-developed, thus they don't realize that they are being exploited. But living in such a state is also a choice.

As such, a more accurate description of the situation is that an individual or group let themselves be used by another. In many (most) cases, the victims are likely complicit in the victimization.

This Time It's Different

"You stop sending me information, and you start getting me some."
--Gordon Gekko

Just finished Reinhart & Rogoff's (2009) book, This time is different: Eight centuries of financial folly. The authors are two econ profs, Carmen Reinhart at Maryland and Ken Rogoff at Harvard. The book is grabbing lots of press because a) it is a novel empirical study of over 200 financial crises of various types (debt defaults, banking crisies, currency collapses, inflations) that span about 800 yrs, and b) the prescient timing of its publication in the midst of our current financial crises--what they call The Second Great Contraction (the First Great Contraction is better known as the Great Depression).

The primary contribution of this book, as I see it, is the notion, reinforced by lots of data, that extreme levels of debt and leverage tilt finanical systems toward crisis.

However, I must admit that, unlike most of the scintillating reviews I've read about this book, I was a bit disappointed. For one thing, I think the title is misleading. The authors suggest that each of these crises corresponded w/ groupthink about the capacity of a country to navigate debt/leverage loads differently compared to the past. But this book is not a study of the collective mindset or social contexts that drove the extreme behavior that tipped situations toward crisis. Instead, it's a study of econometrics surrounding crisis points.

Banking crises represent a primary analytical category here, and the authors categorize the recent meltdown as mainly a banking crisis. However, they largely ignore multi-decade cumulative effects of activities in other categories, such as internal and external debt expansion and inflation, that may have played a role in tipping the system past the point of no return.

Moreover, I found their assessment of the causes of banking crises in general, and the current meltdown in particular, to be shallow and, frankly, typical of mainstream economists. Mobility of capital and regulatary failure, they argue, are primary drivers of banking crises. They largely ignore the question of where all the credit supply has come from over the past 200 yrs to spawn such leveraged states. And they do not consider the role of institutional factors (government sponsored banking insurance programs, interventions in housing markets, et al.) that signficantly distorted markets on their path to dislocation.

In short, they fail to seriously consider the notion that government intervention itself rests at the epicenter of these crises.

Not surprisingly, then, their solution is more regulatory oversight. An expanded role for the IMF and a set of crisis indicators that should be carefully monitored by bureaucrats are among their recommendations.

While Reinhart and Rogoff's (2009) data should elevate awareness of debt and leverage in finanical meltdowns, their superficial analysis of underlying causes limits the capacity of their work for driving meaningful change.

References

Reinhart, C.M. & Rogoff, K.S. 2009. This time is different: Eight centuries of financial folly. Princeton, NJ: Princeton University Press.

Sage View

We
Are young but getting old before our time
We'll leave the TV and the radio behind
Don't you wonder what we'll find
Steppin' out tonight?
--Joe Jackson

Market sage Richard Russell once again offers rationale for gold in this environment. Russell is one sharp cookie--likely the reason why he maintains the longest running investment newsletter in existence--he's been at it since 1958.

While I no longer subscribe to Dick Russell's newsletter, I love catching snippets when they show up. Lately, it appears that he's turned quite bearish based on the technical action layered on top of the increasingly chaotic structural landscape. He's forecasting a retest of the March '09 lows in stocks (and then some).

His preferred asset allocation: cash and gold. Cash to weather a deflationary storm. Gold to hedge against a paper blizzard to stem the deflationary tide.

position in gold

Seeking Beeks

"Nothing you have ever experienced will prepare you for the absolute carnage you are about to witness. Super Bowl, World Series--they don't know what pressure is. In this building, it's either kill or be killed. You make no friends in the pits and you take no prisoners. One minute you're up half a million in soybeans and the next, boom, your kids don't go to college and they're repossessed your Bentley."
--Louis Winthorpe III (Trading Places)

The technical picture in commodity land looks interesting for a trade.

Using a weekly horizon, prices are resting on uptrend support, as well as the 50 day MA. Stochastics are crossing low.

Pretty nice defined risk setup for a trade back toward the top of the channel.

Would also think that if commodities break down right here, then the implications for stocks are likely bearish as well.

position in SPX

Default or Debase

I keep looking for something I can't get
Broken hearts lie all around me
And I don't see an easy way to get out of this
--Cutting Crew

As stress on sovereign debt increases worldwide, pundits maintain that the US will never default on its debt. The US dollar is the world's reserve currency, they argue. Besides, we could always print more dollars if we get hard up.

But isn't currency debasement a form of default? Paying back creditors with worthless currency seems no different from reneging on payments. Plus it crushes non creditors holding USD.

Seems like two paths to the same end: not upholding your obligations as a borrower.

position in USD

Going Retro

So forget all that you see
It's not reality
It's just a fantasy
--Aldo Nova

Barry Ritholtz shares a portfolio of comments on housing, economy, et al. by Ben Bernanke from 2005-2007. Why we continue to listen to Mr Bernanke, given his terrible track record, is indeed mind numbing.

btw, retrospective analysis of bureaucratic commentary is not done often enough. For instance, I recently heard some clips uttered by Barack Obama (on finance exec bonuses, his belief in free markets) and Barbara Boxer (on global warming) that reveal gross inconsistencies in their positions at different periods in time.

Mainstream media rarely engages in this sort of analysis. Instead, it is mostly the product of inquiring minds asking common sense questions.

No Class

My friend the communist
Holds meetings in his RV
I can't afford his gas
So I'm stuck here watching TV
--Sheryl Crow

Karl Marx is often credited with contributing a theory of class conflict to what we 'know.' But as noted by this author, Marx's (1867) class theory offers weak explanatory and predictive power.

Marx proposed two social classes: the capitalists, or bourgeois, who own plant, property, equipment and other assets for transforming input into output, and the workers, or proletariat, who actually do productive work. Marx posited that as greedy capitalists appropriated more and more weath from the system, workers would become poorer and poorer. At some some point, the 'conflict' created by this wealth divergence would motivate workers to overthrow the capitalistic system.

While I am just now dipping into the details of Marx's writings, his general conceptualization of social classes seemingly fails to account for many empirical phenomena. One obvious problem is how to categorize the large number of self-employed workers--those who both own and work simultaneously.

In Marx's framework, owners of small businesses would be considered capitalists and members of the ruling class. Similarly, celebrities and sports starts earning $millions are lumped into the category of exploited workers. Both of these situations seem counter to creating the 'conflict' that Marx proposes will break the system.

Marx also posited that, over time, free market systems would result in the extermination of middle class--which subsequently positions the context for binary class conflict. Yet, there is reason to believe, and empirical evidence to support, precisely the opposite. As entrepreneurs endeavor to meet new buyer needs thru innovation, wealth creation creates a thriving middle class.

This leads to problems in accounting for the upwardly mobile--a problem that Marx does not apeear to adequately address.

Perhaps most critically, Marx failed to fully define what a 'class' is and how we account for divergences between his conceptions and reality. One would think that a theory of class conflict would need to nail down precisely what a class is. As the author speculates, Marx left this question open ended most likely because he could never make this part of his theory 'work.'

In the land of peer review, such a problem should lead to a 'fatal error' and formal rejection of the theory.

That his theory has gained such broad acceptance among academics, despite its serious flaws, may be telling us something.

Reference

Marx, K. 1867. Das kapital, Vol 1. Hamburg: O. Meissner.

Bait and Switch

Howard Prescott: "Let me get this straight. Brantley is Whitfield?"
Brantley Foster: "That's right. Brantley is Whitfield. Whitfield is Brantley."
Vera Prescott: "And Christy is the bimbo. Well, now that we've all had Mousketeer roll call, I'm just going to call my lawyer."
--The Secret of My Success

In a soon to be published interview with Business Week, President Obama proclaims that he and his administration are 'fierce advocates' of the free market.

My first thought was to Hayek's (1944) observation that a favorite Jedii Mind Trick of totalitarian regimes is to twist the meaning of words--words such as 'free markets.'

Judging by Mr Obama's actions, free markets are apparently those that require large amounts of government regulation and, in some cases such as health care, autos, and banking, government ownership and control of production, distribution, prices, and wages.

It doesn't take a scholar to realize that such is not the definition of free markets in the classical sense.

Reference

Hayek, F. 1944. The road to serfdom. Chicago: The University of Chicago.

Brain Drain

"If you think that by threatening me you can get me to do what you want, well, that's where you're right."
--Chris Knight (Real Genius)

Presently, people who qualify as 'intellectuals' (e.g., academics, journalists, pundits) generally seem to be more interested in pursuing political ends than in pursuing the truth. In his 1927 work, La Trahison des Clercs (published in transalated form as The Treason of the Intellectuals in 1928), French essayist Julien Benda, offered an early discussion of this phenomenon.

More than 80 yrs ago, Benda observed the already-in-motion trend that intellectuals were foresaking the principles of intellectual life, such as disinterested judgement and faith in the universality of truth, in order to join politically driven 'cults of success.' Intellectuals were shedding independence in order to be power brokers of the day.

The past few decades have seen this phenomenon escalate. We regularly see politicians trot out willing 'experts', for example, to lend validity to a particular point of view. Other experts pepper commentary on opinion pages of leading newspapers.

Were such intellects truly dedicated to pursuing the truth, then they would not side with 'movements' such as global warming or Keynesian economics where conclusions/findings remain highly contestable.

Perhaps relying on a subset of individuals to do the reasoning or thinking for the rest of society is not a particularly good division of labor.

Rather than outsourcing their capacity for reason to those who are considered 'smart,' perhaps all individuals should diversify their skill sets to include thought processes that pursue the truth.

Reference

Benda, J. 1928. The treason of the intellectuals. New York: William Morrow & Company.

Outer Limits of Debt

"You can run but you can't hide, kid."
--Jester (Top Gun)

Our problem is excessive debt. Current incomes are becoming incapable of servicing it. Over the past couple of years, we have seen a large amount of debt transferred from private to public hands--essentially the socialization of risk.

But governments were already lugging large amounts of debt. Now, as more debt gets piled on their ledgers, gov'ts appear to be maxing out as well. While Greece has been in the limelight over the past couple of wks, credit spreads are widening across the sovereign spectrum.

Then of course we have 'non-sovereign' government entities such as California that appear to be reaching their debt limits as well.

This Ponzi scheme can only last as long as someone is willing to take on ever increasing liabilities. And who picks up the baton for governments?

If no one is willing, then it's either default or inflate.

Trip Trap

I've been feeling so much older
Frame me and hang me on the wall
I've seen you fall into the same trap
This thing is happening to us all
--Crowded House

Referencing our weekend discussion, Hoofy can't be pleased with the follow-up market action today.

An early rally fizzled and indexes sank to the low tick at the closing bell.

Gotta think Boo's now sizing up the prospect of really turning the screws...

position in SPX

Free Feeling

I looked out this morning and the sun was gone
Turned on some music to start my day
Then lost myself in a familiar song
I closed my eyes and I slipped away
--Boston

After another chunky mortgage payment this month, I've reached a personal milestone. Am now carrying more cash than debt. Haven't been in this position since before I commenced home ownership in 1996.

The higher cash:debt, the more liquid you are. Plus you're in a position to extinguish the debt at your discretion. Freedom

Feels good.

Reversal of Fortune

Sweet dreams are made of this
Who am I to disagree?
I travel the world and the seven seas
Everybody's looking for something
--Eurythmics

Last Friday saw an afternoon rally that pulled the markets out of a nasty decline. On candlestick charts, the result is a candle with a long 'tail' and indicative of a 'reversal.' This reversal was accompanied by relatively high volume as well.

After successive days of decline, such a pattern often coincides with a near term low.

In the Dow's particular case, the reversal also took the average back above the 10,000 psychological threshold after an intraday excursion down under.

This setup could lather up the bulls. However, if Hoofy can't get his groove on after Friday's reversal, then Boo's crew will likely bum rush the field.

position in SPX

Climb Every Mountain

"The first rule of this house is discipline."
--Captain Georg von Trapp (Sound of Music)

Nice picture of government spending as a % of GDP since our founding. Includes labels of various meaningful events.

Note the 'spike' effect of all major wars. Observe, that following our first major war, the War of 1812, spending recede after the war to prior levels, which was 1-2% of GDP.

Following the Civil War, we find the same 'recede then level' phenomenon, although we leveled off at a slightly higher level.

This all changed with the turn of the last century, with the commencement of the Progressive Era under President Theodore Roosevelt's watch. In the subsequent 100+ yr period, government spending has lifted from about 3% of GDP to about 45% today. Big differences in the pattern include the non-war spikes in response to economic crises, plus the chronic trend as annual spending increases became a way of life.

This picture demonstrates that it hasn't always been the way it is now.

Round Two

Here comes the rain again
Raining on my head like a tragedy
Tearing me apart like a new emotion
--Eurythmics

Vols are up about 50% over the past two weeks, leading some to suggest that we're experiencing a panic. As sagely graphed by Toddo, however, we're likely far from panic levels.

However, we are starting to see more movement intraday, like the 20 handle snapper that we just witnessed in the SPX over the past hr.

Funny thing about leverage. It can have a calming effect on market movement for many periods as folks borrow and bet. But when folks want to unwind their levered bets, volatility returns with a vengeance.

Big intraday moves revive not yet distant memories of Credit Crunch, round 1.

The price feel suggests that Round 2 may be underway.

position in SPX

Carry On, Carry Out

Masquerading as a man with a reason
My charade is the event of the season
And if I claim to be a wise man
It surely means that I don't know
--Kansas

Sold my long dollar position into another gappy move higher this am. Could the greenback continue higher? Absolutely and I wouldn't be surprised.

But the oscillators are getting pretty twisty on the upside, suggesting that the 'easy' part of this move may be behind us for now (as if any trade is 'easy').

In hindsight, btw, can you see the upside resolution to the textbook reverse head & shoulders pattern?

This is what a dollar carry trade unwind looks like. Stocks, commodities, other risky assets are sold, and dollars are bought to cover.

Still short some S&P which 'should' participate in further carry trade reversal.

position in SPX

Truth or Consequences

Lt Daniel Kaffee: "I want the truth."
Col Nathan Jessup: "You can't handle the truth!"
--A Few Good Men

My sister observes that propaganda is not a phenomenon of Communist regimes only; there is evidence of propagandizing here in the US. Last nite I chewed thru Hayek's (1944) Ch 11 "The End of Truth." In this chapter Hayek discusses the nature of propaganda in socialist regimes.

He argues that a defining feature of socialist propaganda is that it is meant to undermine the sense of and respect for the truth. Myths must be created in order to compel folllowers, and capacity for reason must be stunted in order to motivate compliance.

Hayek argues that the most effective way to get people to accept the validity of a set of arbitrary values is to persuade them that these values are really the same as those which they have always held, but which were formerly misunderstood. Sagely, he observes that the most effective technique to this end is to appropriate old words and change their meaning.

And we have seen just this sort of phenomenon take place over the past century or so. Words such as equality, justice, and, yes, even 'liberal' have had their meanings twisted around. 'Freedom', for example, is reshaped into a concept relating to compliance with the collective. Oxymorons abound.

Hayek suggests that it is difficult to appreciate the degree of confusion which this causes, and the barriers to rational discussion that it creates, without actually experiencing it. I would submit that we are in fact in the midst of such experience, as reflected by the chaotic thought spouted daily by mainstream media.

Hayek notes,

"Gradually, as this process continues, the whole language becomes despoiled, and words become empty shells deprived of any definite meaning, as capable of denoting one thing as its opposite and used solely for emotional associations which still adhere to them."

The weird heuristic seems to be:

a) locate a word important to a freedom loving people
b) change the meaning to something that supports the socialist state
c) keep the word so that people can still feel good about using the word
d) create chaos in processes for rational thought and critical thinking

It is thru rational thought processes that people get closer to the truth.

Socialist regimes need to prevent truth seeking, lest a collective cannot be attained or unchallenged.

To be sure, even in free thinking peoples, only a subset of individuals are likely to engage in independent thought. However, as Hayek observes, intellectual freedom is a prime mover of progress not because everybody may be able to think or write anything, but because any cause or idea may be argued by somebody. As long as dissent is not suppressed, a free society increases the change that some will question ideas ruling over their contemporaries and put new ideas to the test of argument.

Propaganda seeks to overthrow the truth-seeking process.

Reference

Hayek, F. 1944. The road to serfdom. Chicago: The University of Chicago.

Debt Dominos

What will you do when you get lonely
No one is waiting by your side?
You've been running and hiding much too long
You know it's just your foolish pride
--Derek and the Dominos

Credit spreads on sovereign debt of the PIIGS are widening big time this am. If this isn't on your radar yet it should be.

Nearly three yrs ago credit problems reared their ugly heads in 'sub prime' residential real estate sectors. Although many viewed the problem as contained (remember that word?) to a fraction of the market, the next yr and a half proved otherwise. Leverage, expressed via debt and derivatives, has a way of spreading in a contagious manner.

A parallel may be forming here. Iceland was the initial shot across the bow last yr. Now the PIIGS are coming apart. There will be talk that this is an isolated problem, that it is 'contained' to a fraction of sovereign debtors.

But nearly every country in the world is a debtor. And the world is levered at multiples of global GDP.

Potential for the domino effect seems pretty high here.

Hyper Extension

"Son, your ego's writing checks your body can't cash."
--Commander Tom 'Stinger' Jordan (Top Gun)

Standard of living relates to how much of income is consumed as opposed to saved. Generally speaking, standard of living rises with consumption.

Standard of living can be elevated beyond income by borrowing, which permits, in the near term, greater consumption of resources than is possible by income. But such a situation is temporary. Over time, standard of living is likely to fall as individuals allocate greater portions of future income to pay off debt.

Standard of living can also be increased by consuming resources that have been saved in the past. This also is a temporary situation. Once savings have been consumed, then standard of living recedes to lower levels. Plus, no savings remain to buffer against future uncertainty or to invest in productivity enhancing projects.

Folks are recently enthused that Q4 GDP printed at about 5%. The worst must be over, so goes the thinking.

But economic laws are not swayed by hope or ignorance. Over the past year, we have borrowed even more resources to maintain an elevated standard of living that would undoubtedly be much lower otherwise. Standard of living is also being elevated by consumption of isolated pockets of remaining savings via taxes and inflation.

Sustainable increases in future standard of living comes from capital formation--from saving. They do not come from capital consumption--from consuming the saved capital we have left.

GDP increases generated by capital consumption are bad, not good. Given our current situation, lower GDP is necessary to pay down debt and improve capital stock.

Current actions being taken in the name of generating positive GDP growth cut the distance between us and squalor.

Propping Property

Between the searching and the need to work it out
I stop believing everything will be alright
Broken
We are broken
--Tears for Fears

Following up on the previous post, check out this chart taken from the TARP report titled 'Government Support of Residential Real Estate Market.'

No 'tacit' policy here. This is out and out firepower aimed at propping up house prices.

As Pep quoted yesterday from the report: Supporting home prices is an explicit policy goal of the government. (p. 126)

This will certainly end in tears.

Spreading the TARP

Comin' over the airwaves the man says I'm overdue
Sing a song, send money, join the chosen few
--Bruce Hornsby and the Range

On p.2 of this missive, Pepe demonstrates bureaucratic 'logic' in its documented glory.

Of the jaw droppers peppering this report, the winner is perhaps this one:

"Stated another way, even if TARP saved our financial system from driving off a cliff in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car." (p. 6)

I find this a remarkable statement for a government doc.

Doubt the 'reforms' they have in mind mesh well w/ the forces that want to clear this market.

Rap it Up

Yo, I see what I see, day by day
Hopin' that the Lord can pave my way
Have I been forgotten, have I foresaken
Or maybe I'm just wrong
With the moves that I've been makin'
--DMX

A clever video comparing the economic theory of Keynes and Hayek. Hayek, of course, is a proxy for the broader Austrian view. Under the light hearted surface are details that have been well researched.

Exit Stage Left

Neal Page: "He says we're going the wrong way."
Del Griffith: "Oh, he's drunk. How would he know where we're going?"
--Planes, Trains & Automobiles

A 40+ yr comparison of US federal government spending vs revenues is shown below.

Modern day tendency for government to spend more than it takes in (a.k.a. a budget deficit) began in the 1970s and picked up speed in the 1980s under President Reagan. The gap narrowed and actually turned positive (a.k.a. a budget surplus) in the late 1990s under President Clinton. The graphic portrayal of the recent widening of the deficit indicates how extreme the intervention has been.

Let's note a few things.

-->Deficit spending is a bi partisan phenomenon.

-->The budget surplus in the late 1990s was a bubble driven anomoly. Jack stock prices higher and collect a windfall in capital gains taxes. Note that once the tech bubble burst, tax receipts collapsed and the deficit widened as behavior reverted to the long term trend. A similar pattern is evident during the 2005-07 housing price run-up, altho a surplus was never achieved before this bubble popped and we went back the other way. Can you see why Keynes worshipper Paul Krugman is on the record as saying that we need to blow another bubble?

-->Can you see the folly in President Obama's plan to freeze a fraction of the budget after an unprecedented run-up in spending?

-->The widening chasm between spending and income can only be reversed by spending less and saving more. We are currently doing the opposite.