Friday, May 31, 2013

Eliminate Government Imposed Monetary Standards

So they say
Is the root of all evil today
--Pink Floyd

During this insightful interview, Jim Rogers says that he's not for a gold standard--i.e., he's not for a government imposed gold monetary standard. History tells us that government imposed monetary standards of any kind always break down.

Instead, JR advocates that government get out of the way. Let the people decide what they want to use as money.

We can be pretty sure what people would not use: pieces of paper printed in green.

When people have had the power to decide on monetary mediums, they have selected commodity-based money. Tobacco, grain, seashells. Many have been employed. All of them grounded in tangible property.

Over thousands of years, however, one commodity money continually surfaces as superior to others: gold. This is because gold has several characteristics that other commodities can't match in aggregate. These characteristics include scarcity, divisibility, recognizibility, portability, and durability.

It is likely that a free people would once again turn to gold and its close cousin silver.

We can also be pretty sure that they would trade gold by its natural metric: weight. A free people would not force some imaginary unit of measure, such as the dollar, euro, or yen, on the money. Gold and silver trade naturally by weight.

Imagine a world free of currency exchange rates and government monetary manipulation. This is plainly possible and in fact likely if, as Jim Rogers suggests, people take control of the monetary system.

In unhampered markets, it is probable that people would gravitate toward gold based money--a money denominated in ounces of gold.

position in gold

Thursday, May 30, 2013

Bubbles for All

Step right up and don't be shy
'Cause you will not believe your eyes
--The Tubes

So, we have stocks back to pre-credit crisis levels. Bond yields near all time lows. Margin debt back to pre crisis levels. What else? Why, house flipping, of course. Buying and sellling homes for quick profit in some markets is approaching levels last seen in 2005. California markets are particularly hot.

When the Fed first embarked on the QE path many wondered what bubbles the Fed would blow. Stocks? Bonds? Real Estate? Credit?

The answer, we now know, is yes to all. As a last hurrah, the Fed is trying to demonstrate that it can blow bubbles in all markets simultaneously.

positions in SPX, Treasuries

Wednesday, May 29, 2013

Still Buying the Dip

You always said
The cards would never do you wrong
The trick you said
Was never play the game too long
--Bob Seger

Dip buying still dominates the action. Early day weakness is being largely erased by snapback rallies (Snappers) as the day wears on.

Market participants, particularly the algo crowd, have embraced this pattern because it is working. The buy the dip crowd will mindlessly keep doing so until it no longer works.

When Snapper disappears and the long whiskers in the charts turn into full red rectangles, then the tone of the tape will change.

position in SPX

Margin Debt at All Time Highs

"The mother of all evils is speculation--leveraged debt."
--Gordon Gekko (Wall Street: Money Never Sleeps)

In case you haven't noticed, margin debt is now higher than it was at the housing bubble peak. In fact, margin debt is marking all time highs.

The article frets over whether whether margin loans are being used to fund businesses or real estate purchases, or whether the loans are being used to lever up investment accounts.

It does not matter.

If you borrow money for whatever purpose, then you are leveraged. You are extending your lifestyle beyond the capacity of your income. Someone who has a mortgage on a house and also owns stocks is levered in stocks. The mortgage loan enables the person to participate in the stock market more than would be possible otherwise.

Borrowing from any source while participating in stocks essentially puts you on margin.

Currently the system is becoming more leveraged. Leverage increases instability. The greater the instability, the greater the movement once natural forces of the market take control in quest of balance.

position in SPX

Tuesday, May 28, 2013

Former TARP Boss Comes Clean

"Sorry, Mr President, I don't dance."
--Jack Ryan (Clear and Present Danger)

Interesting interview snippet with Neil Barofsky, former boss of the TARP program. You remember TARP (the Troubled Asset Relief Program), don't you? It was one of the original bailout programs devised to stem the 2008 meltdown. TARP was initiated by the Bush administration and continued by the Obama administration. Treasury lifted $700 billion of stinking, illiquid securities, mostly related to mortgages and real estate, off the balance sheets of banks in exchange for T bills.

Barofsky was appointed to oversee the TARP program. He began getting into trouble by asking questions about just where the $700 billion in taxpayer-backed funds was going. He learned what was perfectly predictable prior to TARP. Rather than loaning the funds out, banks used the $700 billion to repair their balance sheets, to engage in carry trades with Treasury and the Fed, and to resume their bonus programs.

He also caught on to the perverse nature of bank bailout terms. Bagehot's Rule states that banks in need of emergency credit should only be offered loans at premium rates. That is what unhampered markets would do. Banks borrowing emergency credit would therefore pay dearly for their prior investment mistakes. In the early days of the Fed and prior, this is what generally transpired.

Barofsky observes that what we've been doing is the opposite. When banks get into trouble, credit backed by the sweat of the American people is offered at a discount. Perversely, healthy banks that did not get access to those emergency discounted funds have to pay more for credit than troubled banks do. Banks that make prudent decisions are therefore penalized relative to those banks that made poor decisions.

It takes no genius to grasp the unfairness of this situation--not to mention the moral hazard that this practice inspires.

He also estimates that in exchange for the $700 billion, taxpayers took on risk amounting to $23 trillion. Only government bureaucrats would deem such a trade worthwhile.

Barofsky's questions found him called on the carpet by the undersecretary of the Treasury. He was told in no uncertain terms that if he ceased with the questions and played along, he could have a nice career once the TARP appointment expired. If he didn't play ball, he would find it hard to find another job.

He decided not to play ball.

position in SPX, Treasuries

Treasury Yields Marking New Highs

No one heard a single word you said
They should have seen it in your eyes
What was going on around your head
--Bon Jovi

Ten year Treasury yields have blown thru resistance and are now marking highs for the year. In less than a month, long bond yields are up about 30%.

The higher sovereign yields go, the more problematic things become for the Fed. Under the funding crisis thesis, we should expect a lagged response from equities if yields continue higher.

Gradually, 10 yr yields seem destined  to become the most watched indicator on trading screens.

position in SPX, Treasuries

Monday, May 27, 2013

What We Don't Remember on Memorial Day

"We're here to preserve democracy, not practice it."
--Captain Frank Ramsey (Crimson Tide)

A few things not celebrated on this day:

1) That all wars since WWII have been unconstitutional. Congress alone has the power to declare war; it has not done so since December 8, 1941.

2) That many of those who 'served' in US military conflicts did so at the point of a gun, i.e., the point of our own guns. Conscription accounted for large fractions of the US military beginning with WWI and continued to do so through the Vietnam War. Those who condone the draft are no different than those who condone slavery.

3) That, since the War of 1812, few instances have occurred where the United States has literally defended its homeland against invasion or aggression by other States. Nearly all US soldiers that we remember today were involved in wars waged on foreign soil. When wars are constantly fought elsewhere rather than on one's own turf, justifying these conflicts on the basis of 'defending freedom,' rather than for aggressive purposes, becomes increasingly delusional.

4) That we have diverted $trillions in economic resources, both human and material, into channels for military goods. Production of military goods does not advance general standard of living. In fact, when deployed in conflict, military goods destroy true wealth, leaving society worse off. Imagine the constraints on standard of living that could have been relaxed with if those mammoth war time resources were poured instead into satisfying needs in the marketplace.

What we should be remembering today is that if we limited armed conflict to those instances where we were truly defending ourselves against outside aggression, then both the United States and the world at large would be better places.

Sunday, May 26, 2013

Morally Hazardous Discounting

Will you recognize me?
Call my name, or walk on by?
Rain keeps falling, rain keeps falling
Down, down, down, down
--Simple Minds

The Fed has suppressed short term borrowing rates to zero. It is buying $90 billion monthly in Treasuries. It has said it supports policies that pushes financial asset prices higher.

In this environment of financial repression, how much is too much to pay for a yield bearing security?

Stated differently, how distorted can discounting mechanisms get in this environment?

position in SPX, Treasuries

Saturday, May 25, 2013

Flowing Hair Half Dollar, 1794-1795

Hair, flow it
Show it
As long as God can grow it

As previously noted, half dollar production got underway in 1794. The initial design was similar to the other silver denominations (dollar, half disme) struck that year. The design is credited to Mint engraver Robert Scot, although his design was based on a pattern 25 cent piece developed by engraver Joseph Wright who died of yellow fever in 1793.

1795 Flowing Hair Half Dollar PCGS F12 CAC 2 Leaves

To operationalize the requirements specified by the Coinage Act, the obverse features a right-facing portrait of Ms Liberty with her hair flowing freely (thus the label 'Flowing Hair' half dollar). The flowing hair was said to signify freedom. LIBERTY appears above with the date below. Fifteen stars (8 left, 7 right), representing the 15 states in the Union at the time, encircle the left and right peripheries.

The reverse features a small eagle perched on a rock with wings spread. The eagle is surrounded by laurel branches. UNITED STATES OF AMERICA encircles the border.

The denomination is not indicated on either the obverse or reverse. Instead, the edge bears the inscription FIFTY CENTS OR HALF A DOLLAR with decorations between the words.

Flowing hair half dollars are slightly larger and heavier than later types because they carried more silver than specified by the Coinage Act. Congress had specified a fineness of 1485/1664, or .8924 for silver coins. However, the mint assayer complained that the fineness was unworkable and that coins would blacken unless they were at least .900 fine. His bosses went along with his claim and permitted a bump in silver content, although producing at the higher fineness meant breaking the law of the land.

Specifications were as follows:

Diameter: 32.5 mm
Weight: 13.48 g
Composition: .8924 silver, .1076 copper
Edge: Lettered
Net precious metal weight: .38676 oz silver

In late 1794, the Mint's rolling equipment broke down. Repairs took several weeks and, as 1794 drew to a close, the Mint still had a number of obverse dies on hand with the 1794 date. Rather than scrapping them, the Mint kept making half dollars marked 1794 into the calendar year 1795 until the 1794 dies became unusable. Production of Flowing Hair halves with 1795 dies then commenced.

Altogether, the Mint produced 23,464 half dollars dated 1794 and 299,680 pieces dated 1795. In 1796, a new design was introduced, making the two year tenure of the Flowing Hair half the shortest of all half dollar types.

The example above comes from the more common 1795 production year. The wear on the Ms Lib's face and on the eagle are consistent with a coin that was well circulated. It is a '2 Leaves' variety, referring to the number of leaves on the inside branches of the laurel wreath underneath the eagle. There is a more scarce '3 Leaves' variety as well. Using Al Overton's seminal classification system of early half dollar die varieties, this coin reflects the O-103A, R-5 die combination.

There is also an interesting 'die cud' or 'cud error' around in the A and M in AMERICA on the reverse. A cud is a die crack near the edge of the coin that becomes so severe that it causes a piece of the die to fall away. The result is a featureless blob on the face of the coin near the rim because the surface of the planchet has not been shaped by the die at that point. Immature coining technology of the period made cuds a much more common occurrence then than now.

To me, the most noteworthy feature of this example is its pleasing appearance. Most 200+ year old silver coins that survived lots of time in circulation develop a gun metal gray look to them. This example above, while well worn, was likely plucked from circulation while some brightness and luster remained. It was then placed in a paper album or wrapped in paper storage for many years. Interaction between chemicals in the storage medium, finger oil from handling the coin, and heat generated the rainbow of color evident today.

Like all old coins, it is also interesting to ponder where this piece has been and what it has seen. After all, it was struck when George Washington was president. If Ms Lib could talk, then she would surely tell some interesting tales about this coin's 218 years of existence.

Friday, May 24, 2013

Japan: Enter the Funding Crisis

Can you picture what will be
So limitless and free
Desperately in need of some stranger's hand
In a desperate land
--The Doors

Fleck thinks that we are witnessing an important juncture in financial history. We are seeing, or perhaps have just seen, the end of the environment that finds people believing that central banks can create financial nirvana via quantitative easing, or money printing.

While his is not a unique thesis, Fleck has presented his case clearly. He has long argued that we will never see an end to zero interest rate policy (ZIRP) until we have a funding crisis--meaning that creditors refuse to buy more sovereign bonds at uber low, manipulated interest rates. He has said that the funding crisis would begin when one of the big sovereign debt markets begins to crack.

Fleck thinks that this has Japan. A couple of days ago yields on long term Japanese government bonds (JGBs) traded thru 1%. This may not sound like much, but it is roughly 3x the yield corresponding to the initiation of Japan-style QE by the Bank of Japan a couple month's back. Imagine rates on 10 yr Treasuries exploding from 2% to 6% in a few days.

Following the move thru 1% by JGBs on Thursday, the Nikkei rallied more than 1%, and then flipped over and closed more than 7% lower.

One mechanism for big-time selling is that higher yields raise borrowing costs and crush carry traders, who must sell risky assets in order to delever.

Fleck likens this move in Japan to early funding problems in the mortgage market in 2007 (New Century Financial, anyone?) where the worst credit gets hit first. It is now a matter of time for realization of a systemic problem to spread in contagion-like fashion.

What comes next is reaffirmation from central bankers of their commitment to 'all in' liqudity (i.e., massive money printing). If markets don't stabilize after than jawboning, then it is comeuppance time for stocks.

position SPX, Treasuries

Repeal the AUMF

You know that if we are to stay alive
Then see the peace in every eye
--Paula Cole

As gaffe and scandal escalate for this administration, we should note that President Obama has made a positive move. Yesterday, he proposed that the Authorization for Use of Military Force law (AUMF) be repealed. After 9/11, the AUMF was passed by near unanimous vote to authorize the president to prosecute a 'war on terror' using US military forces.

That the AUMF is even constitutional and should have ever seen the light of day is certainly debatable. Repealing it would end a war that otherwise has no measurable endpoint.

Old school Republicans are upset, of course, as repealing the AUMF reduces prospects for waging perpetual war.

On the other end of the spectrum, critics suggest that the president's motives are mainly rhetorical, as his actions have fallen short of retracting the aggression that he is now speaking against.

A fair point. But nonetheless, repealing the AUMF would be a step in the right direction.

Thursday, May 23, 2013

Volatility Picking Up

Don't you know we're playin' with fire
But we can't stop this burnin' desire
--Donnie Iris

Market volatility picking up. Big swings in gold, silver yesterday. Ten year sold big yesterday, with yields back up to top of recent range. SPX reversed off its highs yesterday and put in a 40+ handle range.

Big news last night was Japan, with Nikkei down over 7%. Of course, the Nikkei was up more than 50% in the past six months and was going parabolic, so this may be just a 'healthy pullback.'

Thus far this morning domestic stock response has been muted with indexes climbing off open of about -1%.

Remains to be seen whether this higher volatility is just a blip or portends something significant.

position in SPX, Treasuries

Wednesday, May 22, 2013

Another Reporter Investigated by DOJ

"You hear that? That's the press, baby. The press! And there's nothing you can do about it. Nothing!"
--Ed Hucheson (Deadline U.S.A.)

Getting less press than the AP scandal is more aggression by the Obama administration against another journalist. This time the reporter is James Rosen of Fox News. The Department of Justice investigated Rosen, which including dipping into his email accounts, after alleging that he was receiving and offering to publish classified information about North Korea obtained from a government adviser in 2009.

As Judge Nap notes, even if Rosen did everything the DOJ claims in its subsequent subpoena against him, then he did not break the law. Reporters "have an absolute constitutionally protected right to seek news of material interest to the public wherever that news may be."

Evidence continues to mount that this administration, rather than being fully transparent as claimed, has been determined to plug all sources of unauthorized information. The Obama administration has already prosecuted more leakers under the WWI era Espionage Act than all previous administrations combined.

This administration opposes free speech and transparency. It supports gagging and opacity.

Tuesday, May 21, 2013

Coinage Act of 1792 and Half Dollar Production

I want to fly like an eagle
Till I'm free
Oh, Lord, through the revolution
--Steve Miller

After the Constitution was ratified, an early objective of Congress was to commence the coining of money (a power authorized by Article 1, Section 8). Promoting business and trade was high on the congressional agenda. In addition to facilitating a strong economy, a strong sovereign monetary system was widely viewed as a necessary attribute of a legitimate sovereign state--something that the young United States wanted to demonstrate.

Because the production of gold and silver coinage was particularly held as a sign of financial strength, Congress was anxious to get going.

The Coinage Act (a.k.a. The Mint Act) of 1792 established the US Mint (including authorization for the first facility in Philadelphia), key positions at the Mint, and specifications for various denominations of gold, silver, and copper coinage. The act authorized the following denominations:

gold: eagle ($10), half eagle ($5), quarter eagle ($2.50)
silver: dollar ($1), half dollar ($0.50), quarter dollar ($0.25), dismes ($0.10), half dismes ($0.05)
copper: cents ($0.01), half cents ($0.005)

Lower denominations included proportionately lower amounts of precious metal.

The obverse of all gold and silver coins were to employ an image emblematic of liberty, the inscription LIBERTY, and the year of coinage. The reverse was to include a representation of an eagle and the inscription UNITED STATES OF AMERICA.

While production of copper coinage commenced in 1793, there was a delay in production of gold and silver denominations. In addition to operational complications with starting up a new mint, Congress had decreed that key mint personnel needed to post bonds of $10,000 apiece before they could work with gold and silver. While a laudable precaution to protect the American people from fraud, the $10K requirement was an enormous sum by 18th century standards, and the mint personnel were unable to post bond. Congress lowered the bond requirement after the mint director secured the intervention of Thomas Jefferson who was then Secretary of State. The lower bonds were subsequently posted, and precious metals coinage began in 1794.

The first silver coin produced was the dollar. Being the largest and having the highest face value, dollars were viewed as possessing the most prestige. Early dollars did little to solve a solution to the nation's monetary needs, however, as coining presses had trouble coping with the coin's size and design. The presses constantly broke down during dollar production.

Silver coin production shifted to the more manageable half dollar denomination. In addition to being easier to make, the half dollar was a popular denomination for everyday trade and well utilized in circulation. It was a coin for Everyman, and remained that way for more than a century.

Given the half dollar's centrality to monetary US history, future posts will profile the various silver half dollar designs (a.k.a. as 'types') employed during the 'hard money' days of the United States. Six primary types were produced from 1794 through 1947.

Monday, May 20, 2013

Decaying Extremes

The foulest stench is in the air
The funk of forty thousand years
And grizzly ghouls from every tomb
Are closing in to seal your doom
--Michael Jackson

In his weekly comment, John Hussman plots past instances of the overvalued, overbought, overbullish extremes in the SPX that we're currently witnessing.

In addition to the relationship between the extremes and market tops, the increased frequency of extreme occurrences is also interesting. While certainly not a perfect fit, the pattern resembles a half life (i.e., exponential decay) function.

Also reminiscent of the diminishing returns concept--recently observed w.r.t. QE.

position in SPX

Long Train of IRS Abuses

"Of all the ideas that became the United States, there's a line here that's at the heart of all the others. 'But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design that reduces them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and provide new Guards for their future security.'"
--Benjamin Franklin Gates (National Treasure)

Ron Paul observes that the IRS/Tea Party scandal is only a recent instance of a long train of bipartisan abuses of the IRS for purposes of harassing political opponents. FDR, JFK, LBJ, Nixon and others precede the Obama administration in this regard.

Chief Justice John Marshall said that the power to tax is the power to destroy in McCulloch v Maryland (1819). It is interesting that he observed this axiom in a case where he and other justices employed the principle of judicial review to expand federal government power.

Nevertheless, it took nearly 100 years for the Sixteenth Amendment to come into existence and, with it, central government's power to marginalize any entity not favored by the current regime.

RP rightfully concludes that the only way our freedoms can be protected against this abuse is to repeal the Sixteenth Amendment, which would shutter the IRS permanently.

Sunday, May 19, 2013

What Gets Measured Gets Manipulated

David Norris: Who the hell are you guys?
Richardson: We...are the people that make sure things happen according to plan.
--The Adjustment Bureau

The federal government spends tens of $billions on economic data collection and reporting. Why? This is clearly not a constitutional use of tax dollars. Moreover, politicians have incentive to rig the data in their favor, which they clearly do.

It is said that what gets measured gets managed. In the case of government, it is more accurate to say what gets measured gets manipulated.

Saturday, May 18, 2013

Monetary Policy and Wealth Disparity

"It's the story of the greatest wealth transfer in the history of the world."
--Jake Moore (Wall Street: Money Never Sleeps)

Stock markets are marking all time highs with over 75% of days in the last month and nearly 2/3 of days in 2013 finishing in the green.

It has been Fed chair Ben Bernanke's stated goal to goose equity prices higher and thus far he is succeeding. He is printing another bubble.

I am amazed at the intellectual dishonesty of people who are concerned about growing wealth disparity in this country yet remain silent about the effects of monetary policy on exacerbating that gap. As of 2007, the wealthiest 1% in this country owned nearly 40% of US stocks by value. The top 10% owned over 80%.

Since 2007, we can be sure of two things. Equity ownership among the top few percent has become even more concentrated. And the chasm between the rich and poor has grown wider thanks to government force in the form of monetary policy.

position in SPX

Friday, May 17, 2013

Causal Loop Diagrams and Interventionist Policy

There's a room where the light won't find you
Holding hands while the walls come tumbling down
When they do
I'll be right behind you
--Tears for Fears

Previously we demonstrated how causal loop diagrams illuminate the workings of economic systems. In this post we'll extend the concept to pinpoint fatal errors in current interventionist policy.

Prior to that, we need to add another loop to the symbiotic economic system portrayed last time. We noted that saving drives interest rates lower which in turn drives borrowing higher. This borrowing promotes consumption and capital investment.

But borrowing also spurs the buying of financial assets such as stocks, real estate, and bonds. Particularly in the case of bonds, the more bonds that are bought with borrowed money, the lower interest rates go. This creates a feedback loop, let's call it the Speculation Loop, that locally takes on reinforcing character. Lower interest rates drive speculation in bonds, which pushes interest rates lower still.

In unhampered markets, however, the reinforcing capacity of the Speculation Loop is limited. As bond buying pushes interest rates lower, savings are depleted. At some point, lower savings push interest rates higher and send the reinforcing Speculation Loop in the opposite direction. Thus, the Speculation Loop is held in check by the amount of savings in the system. An overall balancing effect is present.

As we highlighted last time, causal loop analysis suggests saving as the critical variable in the system because it regulates the pace of the Existence Loop, the Debt Loop, the Investment Loop, and, now, the Speculation Loop.

Unfortunately, what we have right now is not a natural, symbiotic system. Policymakers are messing with Mother Nature in attempts to push economic progress beyond the capacity of natural law. Through their market interventions, policymakers are trying to circumvent the regulating effect of savings on the economic system.

Essentially, policymakers seek to do this by injecting 'fiat credit' into the system. Fiat credit, also known as bank credit, can be viewed as 'false savings' in that it is not grounded in production that has been set aside rather than consumed. In the natural economic system modeled above, production that is not consumed forms the basis for 'true savings' that can be loaned to borrowers. Because loans grounded in true savings represent real economic resources, this type of credit is sometimes called commodity credit.

The source of fiat credit is central banks. Only central banks can get away with creating credit out of thin air, because they are backed by the force of government which can print money or tax citizens to mend balance sheets and maintain solvency.

As shown in the diagram below in red, fiat credit is injected into the system as a substitute for real savings. Interest rates now depend on the supply of false savings which, in a fiat world, is virtually unlimited--meaning that interest rates are likely to be driven lower (at least for quite some time) by fiat credit. The previous relationship between real savings and interest rates is therefore broken. Real savings can still be borrowed, but real savings no longer has a governing influence on interest rates. 

Because interest rates no longer depend on the supply of savings, lower interest rates spur ever more borrowing which, in turn, consumes ever more savings in the Debt, Investment, and Speculation Loops. The critical long term consequence of this policy is to deplete savings.

At some point the system freezes when saving declines to the point where there are no longer enough real economic resources set aside to support the Debt, Capital Investment, and Speculation Loops.

Policymakers mistakenly believe that fiat credit created from thin air can elevate economic performance. Tragically, however, the ultimate effect of this intervention is impoverishment.

Thursday, May 16, 2013

Trampling the Constitution in the Name of Safety

We can dance if we want to
We can leave your friends behind
'Cause your friends don't dance and if they don't dance
Well, they're no friends of mine
--Men Without Hats

Judge Nap frames the recent scandals surrounding the Obama administration in the context of safety versus freedom. Government is legalized force. Because everything it does employs that force to either prohibit or compel, government interferes with freedom. Everything government owns it has taken from others.

It is possible, however, that a small amount of government could extend freedom. If it is limited to helping individuals defend their person and property from aggression by others, then people may be more free than if they had to spend all of their time defending themselves.

The framers understood this concept and put forth a constitutional design that restrained what the federal government could do. The founding principle, as famously stated by Patrick Henry, was freedom over safety.

What we have today is a central government that regularly does the opposite. Bombing Libya, running guns to Syria, the Patriot Act, et al. are commonly justified in the name of keeping people safe--even if it means compromising individual liberty.

This administration is doing nothing new in principle; it is merely escalating policies initiated by previous administrations.

But this does not absolve this president of blame. If you inherit bad policies, then you cease them. You do not preserve or escalate them.

As the Judge observes, a president who keeps us safe but not free is not doing his job.

Wednesday, May 15, 2013

Owning a Problem

"Two words, Mr President. Plausible deniability."
--Albert Nimzicki (Independence Day)

My earliest recollection of the Iran Contra affair was that of sitting in Detroit Metro catching up on reading in between flights. An article suggested that Reagan had no knowledge of the extent of the contra programs and deserved no blame for the scandal.

Ridiculous, I thought. Either the president did know and was lying, or he is guilty of incompetence for not knowing. Either way, blame for significant mistakes in any administration, be that administration public or private, for profit or not for profit, rests with the chief executive.

The bigger the problem, the more blame percolates to the top.

President Obama continues to shirk responsibility for administrative miscues done on his watch. Most recently, scandals build surrounding the Benghazi incident, IRS targeting of Tea Party and other groups, and record grabbing from the Associated Press.

The president has accepted blame for none of them. In some cases, the president and his administration seem to deny that a problem exists with their people. In other cases, the president points fingers at lower level people in his administration.

Indeed, apologists for this president suggest that there is no way that he should be expected to know all of what goes on underneath him. All of what goes on, no. Major issues that result in loss of life and constitutional infringement, absolutely.

Moreover, if the executive branch is so large that the president is truly unable to monitor substantial issues going on underneath him, then isn't this supportive of arguments for smaller, more limited government?

Institutions famously take lives of their own, relegating individual initiative responsibility to the background in favor of a collective construct. Wouldn't it be refreshing to see a chief executive break out of the institutional iron cage and personally own a problem?

Tuesday, May 14, 2013

Causal Loop Diagrams and Economic Systems

We are passengers in time
Lost in motion, locked together
Day and night by trick of light
--The Fixx

Causal loop diagrams improve understanding of complex systems where variables work together in non-linear fashion (Senge, 1990). Feedback loops can be included to capture balancing or reinforcing effects. Let's try our hand at applying causal loop diagrams to economic systems.

Central to all economic activity is production and consumption. Alleviating axiomatic scarcity in resources required for existence and prosperity necessitates production. Production is the combination of labor with tools and materials that generates resources that can be consumed.

Consumption equates to standard of living. When consumption increases, standard of living goes up.

Here is a simple causal loop diagram that reflects the relationship between production and consumption:

The (+) means that production and consumption move in the same direction. The higher (lower) the production, the higher (lower) the consumption (and standard of living). Consumption feeds back to production. Consumption provides metabolic energy to enable future production. When consumption drops off, capacity for production does as well.

Because people have insatiable needs, then production and consumption are likely to reinforce each other over time in an "upward spiral of mankind" sense. But we know this loop as drawn is overly simplistic--other factors can influence this basic relationship in positive and negative ways.

Let's expand the system to account for more variables. While people can produce more by working longer, they can also produce more by being more productive--i.e., when they generate more output per unit of hour of labor.

Higher productivity requires investment in tools and equipment that enables labor to be more productive. Capital investment is only possible if some fraction of previous production is saved rather than consumed. As more is saved, interest rates (the price of borrowed savings) goes down, making it more attractive for tool-making entrepreneurs to borrow. The toolmakers convert some of the savings into capital equipment, and consume the rest (toolmakers must eat, after all). The expanded picture looks like this:

We begin with our original production-conumption loop in the upper left portion of the diagram. Now, however, there is another arrow coming out of the loop from consumption. Saving requires less consumption, thus the (-) betwen consumption and saving. Saving in turn has a negative relationship with interest rates. The greater the supply of savings, the lower the rate of interest on borrowed money (because there is more savings available to borrow).

Lower interest rates mean more borrowing, and vice versa. Borrowing can precipitate either a) capital investment (e.g., investing in tools) or b) more consumption (e.g., using loan to go on vacation).

When borrowing is used for solely for consumption, note that this reduces savings. Also note that saving's siphoning effect on consumption which reduces the 'virtual cycle' effect between production and consumption implied by our initial diagram above. With borrowing siphoning consumption, the production-consumption loop assumes a more balanced posture. We might call the production-consumption loop the 'Existence Loop' as it signifies the basic human process of working to live.

The loop created by borrowing to consume might be called the Debt Loop. When we borrow to consume, we take on debt. Savings are depleted and interest rates increase, which retards more borrowing. The Debt Loop is therefore a balancing loop.

When borrowing is used for capital investment, production goes higher. This is the Investment Loop. The increased productivity realized via the Investment Loop can take the entire economic system higher in reinforcing, virtuous cycle fashion, but only if saved resources are channeled in that direction.

In fact, perhaps the key take-away from this exercise is the critical role of savings in expanding productivity over time. It is readily apparent that if all production is consumed and nothing is saved, then capital investment is not possible.

The above diagram is not perfect, but it provides a sense of the dynamics that define economic systems in their natural, unhampered state.

In a future post, we'll add a final loop to the above diagram to further enhance its realism, and consider the destructive effects of policy intervention in the economic system.


Senge, P. 1990. The fifth discipline. New York: Doubleday.

Monday, May 13, 2013

Federal Government Grabbed AP Phone Records

"You guys are pretty tired, right? Well, you should be. Go on home. Get a nice hot bath. Rest up...15 minutes. Then get your asses back in gear. We're under a lot of pressure, you know, and you put us there. Nothing's riding on this except, uh, the first amendment to the Constitution, freedom of the press, and maybe the future of the country."
--Ben Bradlee (All the President's Men)

As the Benghazi and IRS/Tea Party story lines continue to unravel for the Obama administration, another headline is hitting the tape that the Federal government obtained phone records of Associated Press reporters and editors in 2012.

These episodes combine to demonstrate the administration's attempts to make a mockery of the Constitution--particularly w.r.t. the First Amendment.

I can think of no better way for a president to alienate a media that has been in his back pocket than to oversee a government that suppresses or undermines free speech.

If the media wakes up, then this administration is headed to the gallows.

Traditional vs Contemporary Money Printing

Claire Kuchever: What if you had to tell someone the most important thing in the world, but you knew they'd never believe you?
Doug Carlin: I'd try
--Deja Vu

Doug Noland distinguishes between two types of money printing. Traditional, 'old school' money printing involved the creation of cash and distributing it into the real economy. Those inflations of old raised general price levels and reduced purchasing power.

Such traditional money printing is a thing of the past. The contemporary printing press is an electronic, virtual one. Not only is modern money 'printed' in the form of bits and bytes, but it is distributed directly into the financial system rather than into the general economy.

Uneven distribution of modern money creates privilege for those in the financial system who get their hands on the newly printed cash before others. They can buy assets like stocks, bonds, and real estate at relatively low prices, and then sell them to late comers at higher prices.

Because the newly printed cash is not widely disbursed, general prices remain largely subdued. Where prices do take off is in the financial markets. Stocks, bonds, houses, commodities--whichever markets become the object of speculation.

Meanwhile, deceptively referring to scoreboards more appropriate for monitoring traditional rather than contemporary inflation, central bankers and the privileged recipients of the cash point to benign consumer price indexes as evidence that contemporary policies are not hurting the system--suggesting, perhaps, that the system could withstand even more money printing.

The public, seemingly unable to comprehend the enormous wealth transfer scheme taking place before its very eyes, naively nods in agreement. What's good for financial markets must be good for the economy, they figure.

Of course, we know how this movie ends. Leveraged speculation pushes asset prices higher until the Ponzi finds no more buyers. Speculators rush toward the exits and asset prices collapse.

The speculators then go to policymakers with hat in hand, and request more contemporary money printing in order to keep the system from collapsing.

Wash, rinse, repeat.

position in SPX, Treasuries

Sunday, May 12, 2013

Do Your Best

"Go on, lean in. Listen. You hear it? Carpe--hear it? Carpe...carpe diem. Seize the day boys. Make your lives extraordinary."
--John Keating (Dead Poets Society)

The first agreement was be impeccable with your word. The second agreement was don't take anything personally. The third agreement was don't make assumptions.

The fourth and final agreement is always do your best. Doing your best means living effectively and staying engaged in those activities that you deem most important.

Only you can gauge what you best is. No one else can do it for you.

There is a zen riddle: If you seek it, you cannot find it. Doing your best means staying focused on actions rather than outcomes. Revel in the process. Keep working to get better. The results will naturally follow.

Mastery comes from practice.

Doing your best also means letting go of the baggage of the past. The past is useful as a learning tool or for the occasional fond memory. But it should not be a source of regret or an anchor that ties one to times gone by.

Uncertainty about the future can also impair best behavior. Some attention to tomorrow is necessary for planning purposes. But it should not be a source of worry or anxiety that grates on present action.

Doing your best means acting effectively, drawing when necessary from past and future, in order to live fully in the here and now.

Saturday, May 11, 2013

Natural Rate of Leverage

"Unfortunately, the further you run from your sins, the more exhausted you are when they catch up to you...and they do."
--Dalton Russell (Inside Man)

Bank leverage generally runs 10:1 or more. This means that banks only hold about ten cents of every dollar deposited. The rest is loaned out or invested.

This amount of leverage is not natural and would not persist in unhampered markets. The only way systemic leverage could be this high is by edict and intervention. Government permits banks to operate with only a fraction of equity and bails out the system when inevitable margin calls (read: bank runs) materialize.

This does not imply that unhampered markets would operate with no leverage. Money would still be loaned or invested in projects deemed worthwhile.

However, the source of those loans would be commodity credit instead of bank credit. Commodity credit comes from real savings-commodities that have been set aside and not consumed. Bank credit is only loosely tied to savings. If a bank has $100 of savings in deposits, then it is legally permitted to create $900 (or more) of credit out of thin air.

The natural amount of leverage in unhampered markets is likely to approximate the general savings rate. The more savings, the more commodity credit available to lend out or invest. Moreover, banks could withstand large amounts of withdrawals from depositors without being rendered insolvent.

Leverage much higher than the savings rate is unlikely to persist in unhampered markets because bank runs driven by depositors nervous about the prospects of not being able to withdraw their funds would generate bankruptcies. Without the back stop of government-sponsored bailouts, people would more prudently vet alternatives for depositing their savings and institutions would more prudently select lending projects.

As such, claims that unhampered markets create conditions of bank instability are clearly misguided. In unhampered markets, bank leverage is low and regulated by buyers and sellers in the market. In hampered markets, bank leverage is high and regulated by bureaucrats.

Friday, May 10, 2013

Tea Targeting

"They want what any first term administration wants. A second term."
--Robert Ritter (Clear and Present Danger)

In early 2012, complaints began surfacing from many Tea Party affiliated organizations that they were the subject of tax scrutiny by the IRS. Other groups of other political persuasions were not undergoing such review. It was straightforward to construe that the IRS was unfairly targeting Tea Party groups. Government officials denied it at the time.

Now the IRS admits it.

Amazingly, the WaPo piece does not report what drove officials to reverse their previous stand. It also does not report on any consequences of the targeting. For example, did the targeting impair Tea Party groups from getting organized ahead of last Fall's election?

These are obvious questions that any responsible journalist would pursue.

Hyper aggressive Fed policy. Data manipulation. Benghazi. Targeting of Tea Party organizations. All ahead of the November election. The dots are there for connecting. The picture is that of an administration hellbent on tilting the election table in its favor. Yet few media want to pursue this story.

The media also do not want to suggest that government targeting of politically oriented groups is a prime expression of tyranny.

Thursday, May 9, 2013

Benevolent Voice of Tyranny

"Why should I trade one tyrant three thousand miles away for three thousand tyrants one mile away? An elected legislature can trample a man's rights as easily as a king can."
--Benjamin Martin (The Patriot)

Last weekend, Barack Obama delivered the commencement address at Ohio State University which included the following:

"Unfortunately, you've grown up hearing voices that incessantly warn of government as nothing more than some separate, sinister entity that's at the root of all our problems; some of these voices also doing their best to gum up the works. They'll warn that tyranny is always lurking just around every corner. You should reject these voices. Because what they suggest is that our brave and creative and unique experiment in self-rule is somehow just a sham with which we can't be trusted."

I laughed when I first heard these lines, and then thought the president should brush up on his American history. As Judge Nap observes, the United States was born out of mistrust for government. Government is legalized force. And because people prefer leisure over work, and less work to more work, they are prone to employ the force of government to satisfy their needs on the backs of others.

History continually demonstrates that special interest groups and government officials themselves seek to employ the strong arm of government for personal gain. This strong arm is perpetually looking to extend its reach. Having experienced the theory first hand, the founders sought to frame a government whose reach would be expressly limited.

Stated differently, the principles underlying Constitution are grounded in mistrust of government and its incessant tyrannical reach.

The president's use of the term 'self-rule' was also curious. Literally defined, self-rule means rule of one's self. It is not rule by others, whether those others are many or few. With government confiscating more than one third of all production, we are hardly operating under conditions of self-rule today.

Indeed, to suggest we currently have self-rule is the real sham.

The voices that we should be rejecting are those such as yours, Mr President, that suggest, "I'm from the government and I'm here to help."

The benevolent voice of tyranny.

Wednesday, May 8, 2013

Sitting Out Stocks

"The mother of all evils is speculation--leveraged debt."
--Gordon Gekko (Wall Street: Money Never Sleeps)

Years ago I remember my uncle telling me that he would not buy stocks. Stock markets are too risky and perhaps even rigged, he said. Of course, he was born in the 1920s and likely had vivid memories of The Crash and Great Depression. And, of course, WWII.

Many from his generation had similar attitudes toward equities after those terrible economic experiences were seared into their memories.

It is easy to scoff at people from the "Greatest Generation" as being too risk averse. Many sat on the sidelines while the biggest bull market in history unfolded before their eyes.

Funny thing is that my uncle and others of his ilk have done just fine without large stock market exposure. They saved heavily. Now in retirement, they live comfortably from those savings.

In fact, it can be argued that many of today's investors are carrying too much risk. They have not saved enough. As such, they hope that positions in stocks and bonds, often leveraged, will appreciate enough to compensate for their lack of savings.

There is also a growing demographic that once again is shunning stocks--presumably after being burned too many times in the last 10-15 yrs. Even with market indexes hitting all time highs, many of these people have ignored the siren sound of higher stock prices.

As likely occured the 1930s, 1940s, and 1950s, many market pundits are waiting for these people to come back into stocks, and propose that this prodigal return to equities will propel markets much higher.

But this group may not ever be back.

Stock markets went up big (and down big) while my uncle and others of his time sat on the sidelines.

Why should it be different if a new group decides to sit this one out?

position in SPX

Tuesday, May 7, 2013

Government and Investing

"They are going to take you."
--Bryan Mills (Taken)

The Obama administration often refers to the spending that the federal government is doing as 'investing.' Can this rhetoric be taken seriously, or is it just political euphemism?

Commonly defined, investing is committing money to an endeavor in anticipation of earning an economic return. An economic return means that, over time, more money is gained than is put into the project (a.k.a. return on investment or ROI).

Implied by this definition is that investing is a voluntary activity. Investors decide whether to commit their capital or not. They are not forced to do so.

We can therefore observe one thing wrong with referring to government spending as investing. Government does not commit its own capital to a project. Instead, it uses funds collected from others. And unlike private sector money managers who act as investment agents for willing principals, government obtains its funds by force.

Committing proceeds forcefully obtained from others toward an economic endeavor is not what a money managers does. It is what a thief does.

Suppose, however, that we temporarily embrace the socialist's argument that, despite the use of force, government is nevertheless investing because it is committing capital for the 'public good.' The capital that it is allocating is collectively owned by 'society,' and government serves as money manager for the collective.

In order to be an effective investor for the collective, government must overcome a classic agency problem. Government officials who allocate funds serve as agents for public principals. Because they are allocating other people's money, the government agents face a different risk:return profile than their principals.

If they make poor investment decisions, government monetary agents face different consequences than their collective principals. Yes, government agents could be fired by their principals but that might mean merely a return to private sector employment. But behavior of government agents can be difficult for the public principals to monitor, making it difficult for the collective to assign blame for poor investment decisions.

Meanwhile, the collective gets hit with real economic loss. Less comes out of government programs than goes in. To make up for the lost economic resources and maintain their standard of living, citizens have to a) work harder and/or b) borrow resources from others.

Of course, these are precisely the kind of results we see being posted on the economic scoreboard. People are working harder. Federal debt has been exploding higher. Standard of living has been slipping for many Americans.

The question to be asking is this: If the federal government is an effective investor, then why are we observing such results?  

Monday, May 6, 2013

Extreme Futures Sentiment

See the stone set in your eyes
See the thorn twist in your side

One way to gauge sentiment in markets is to examine the positioning of 'speculators' in futures markets. If you open a futures account, you must identify yourself as either a speculator or a hedger. A speculator buys or sells a futures contract with the hope of making a profit.

While it might seem that all market behavior is speculative, some people participate in futures markets to reduce risk. A farmer, for example, might short corn futures to lock in a particular selling price for his crop. These people are 'hedgers'--they typically do business in the actual commodity and use futures to manage price risk.

Both speculators and hedgers are necessary to make markets in futures contracts. Without speculators, hedgers would have no counterparty to which they could lay off risk.

All futures contracts positions are tagged as belonging to either speculators and traders. Reports of these data can be useful for gauging sentiment among these two groups of market participants.

Current data indicate that large specs are very long US equity index futures. The last time large specs were this long SPX futes was, yep, fall of 2008.

Other noteworthy extremes in large spec positioning are in Japanese Yen (large net short) and gold/silver (low net long).

The positioning of speculators is often an effecitve contrarian indicator at extremes. Specs are often longest at market tops and shortest at bottoms.

Couple present large spec positioning in equity futures with 20 yr highs in equity margin debt and you have the recipe for epic optimism among stock market participants last seen in 2008.

position in SPX, gold, silver

Sunday, May 5, 2013

Seth Klarman, Cash, and Risk

Illusion never changed
Into something real
I'm wide awake and I can see 
The perfect sky is torn
--Natalie Imbruglia

More thoughts from Seth Klarman's recent letter. You can tell that he is feeling the red-line right now. It is also clear that he anticipates major downside in stocks. He notes:

"When just about everyone heavily invested is doing well, it is hard for others to resist jumping in. But a market relentlessly rising in the face of challenging the riskiest environment of all."

He appears to be holding large cash balances in order to take advantage of lower prices. He notes how stupid one can look for holding cash when it's earning nothing.

This continues to be a most difficult decision for me. How much cash to hold? As Seth notes, cash provides flexibility. It is necessary to have cash on hand at market bottoms, as few people have cash to purchase bargains at this point.

On the other hand, policymakers are doing everything they can to debase the value of cash. Spending dollars now before prices rise, or converting them into other assets capable of preserving purchasing power seems prudent.

Such binary scenarios are products of financial oppression.

position in SPX

Saturday, May 4, 2013

Two Hedge Fund Letters

Now that your rose is in bloom
Your light hits the gloom on the gray

A couple of months back, legendary hedge fund manager Stanley Druckenmiller spoke about the risks that current policies pose for our future. Two more hedge fund legends issued warnings of their own in recent shareholder letters.

Seth Klarman suggests that everyday citizens appear to understand our monetary and fiscal situation better than politicians and prominent economists. They are wary of believing promises issued by those who failed to see to previous housing bubble coming. They understand that you cannot borrow your way out of debt, and distrust bargains that kick the can down the road.

They sense "that if the economy is so fragile that the government cannot allow failure, then we are indeed close to collapse. For if you must rescue everything, then ultimately you will be able to rescue nothing."

Paul Singer focuses on the destructive actions of the Federal Reserve. He notes that 2007 FOMC meeting minutes make clear that the Fed was clueless about the degree of risk and contagion building in the system prior to the credit bust. The Fed is unable to comprehend the current state of financial markets and the ultimate consequences of its ever escalating experiments in monetary debasement.

He sees two broad paths that clearly emerge from Fed policy as enacted under Greenspan and Bernanke. One is the path of arrogance hewn from the cult of central banking, where the Fed acquires 'maestro' status. The other is the path of lost discipline that destroys confidence in fiat currency and leads to monetary ruin.

"We believe that the global central bankers, led by the Fed as 'thought leader,' have no idea how much pain the world's economy will endure when they begin the still undetermined and never-before attempted process of ending this gigantic experimental policy." In fact, he thinks it likely that, even if/when the Fed figures out that the social cohesion can only be maintained by stopping the monetary printing presses, the Fed will be reluctant to do so in order because it will not want to accept blame.

When the epic collapse that awaits gets underway, policymakers will once again come out of the woodwork proclaiming that no one could have foreseen the problems. As these letters will demonstrate, the situation was surely knowable. Many saw it coming.

Friday, May 3, 2013

Financial Repression is Oppression

Step right up, and don't be shy
Because you will not believe your eyes
--The Tubes

The situation that we are currently in, where governments worldwide are forcing interest rates to near zero or even negative levels, has become known as 'financial repression.'

This situation is more accurately labeled financial oppression.

By grinding interest rates into the ground, monetizing their own sovereign debt, and buying risk assets such as stocks, governments have laid waste to opportunities in the investment landscape. Investors face no good choices; they are presented only with choices that are less bad. Around the world, this is driving market participants to take more risk than they otherwise would.

Meanwhile, by printing money, government creates claims on the production of others. Wealth is being transferred from producers to non-producers.

Worst of all, policies that encourage consumption and penalize saving are depleting the system of capital vital to improving productivity and future standard of living.

This is the cruelest of oppression. Robbed of current economic resources. Tricked into decisions that will impoverish us in the future.

position in SPX, Treasuries

Thursday, May 2, 2013

Reinhart Rogoff Redux

So put in your earplugs
Put on your eyeshades
You know where to put the cork
--The Who

Regarding the recent uproar over errors in Reinhart and Rogoff's research, RR have aggressively defended their findings. The 'spreadsheet errors' detected by the UMass group do not substantially alter the empirical findings. As this NYT graphic demonstrates, the relationship between economic growth and debt is negative regardless of which analysis is examined.

It is interesting that the media continues to paint RR as fiscal hawks. After reading RR's This time is different, I noted with disappointment that RR's analysis of their own results appeared shallow and avoided the issue of the role of government policy in financial crises. The notion of 'austerity,' which was a logical implication of their findings, went little discussed in the book.

Today, even while defending their work, RR claim that they are not fiscal hawks. In fact, they suggest, "No one should be arguing to stabilize debt, much less bring it down, until growth is more solidly entrenched - if there remains a choice, that is."

This is a stunning statement, really, in light of RR's own research to the contrary. It is suggestive of an institutional mindset that impairs capacity for interpreting one's own findings.

Caroline Baum observes that the recent uproar over the exact threshold where debt compromises growth misses the point. "Too much debt is bad." She explains, "You don't need a doctorate in economics to understand that you can't spend beyond your means forever, or that piling on debt because it's cheap to borrow isn't sound policy."

That we're seriously debating this point demonstrates just how far off the rails from basic economic understanding that we've traveled.

Wednesday, May 1, 2013

Market Makers and Flash Crashes

"Blue Horseshoe loves Anacott Steel."
--Bud Fox (Wall Street)

Previously we discussed the role of increasingly fragmented exchange structure in precipitating flash crashes. Fragmentation alone does not adequately explain the phenomenon because modern arbitragers can quickly eliminate gross mispricings that might occur on a particular exchange.

Other factors, such as the evolution of market makers alongside changes in exchange profit status and order flow offer more explanatory power. Market makers are employed by exchanges to take the other side of trades within a reasonable, often pre-defined spread. The smaller the spread between the bid and ask price for a security, and the more volume that can be done in that spread, the more 'liquid' that security is.

Exchanges pay market makers to provide liquidity in order to attract customers who may be hesitant to do business on the exchange unless they are confident that trades can be executed near prevailing quoted prices. In return for providing liquidity, market makers are compensated by the exchange in the form of information and trade execution privileges as well as rebates for shares traded at quoted bid/ask prices.

In their more concentrated days, exchanges were run as non-profit mutual organizations. The exchanges were funded by the institutions they served. They were not treated as profit centers. Because retail and institutional investors dominated the order flow, exchanges were motivated to employ market makers who kept spreads narrow for the retail and institutional flow.

Today's fragmented exchanges are run as for-profit entities. No longer funded by institutions on a non-profit basis, modern exchanges must seek sources of revenue. Primarily, these revenues take the form of fees from trading customers.

But today's customers are no longer retail and institutional investors. Instead, order flow is dominated by firms engaging in high frequency trading (HFT). HFT, also known as algorithmic or 'algo' trading, is primarily the domain of hedge funds and proprietary trading desks (a.k.a. 'prop desks').

HFT is short term and momentum-based. Liquidity is not necessarily a friend of the algos. In fact, algos may seek to create temporarily illiquid situations in order to scalp profits created by wider spreads.

Because today's exchanges depend on HFT customers for profits, and those HFT customers may not value liquidity, the role of market makers in this arrangement becomes unclear. Seemingly, exchanges have less need for 'old school' market makers since primary order flow is no longer liquidity dependent. Absent incentive to keep spreads tight, market makers are less likely to take the other side of trades that they aren't being compensated for.

Moreover, market makers often run their own prop desks and engage in HFT themselves. Because they are granted privileged views of order flow, market makers can insert this info into their algorithms and perhaps gain advantage over non-market-maker HFTs. Accusations of 'front running' are increasingly common, where market makers are seen as executing trades ahead of other exchange customers. Last week's AP tweet flash crash, for example, has been said to have been caused by market maker prop desks getting a head start on other algos.

The sheer volume done by front running market makers, who both a) are no longer governed by strict liquidity mandates by the exchanges and b) might operate on multiple exchanges, make it difficult for arbitragers to quickly narrow gross mispricings--thereby leaving the system more vulnerable to the flash crash phenomenon.

Some people, such as the Santelli Exchange guest in the second video here, appear to want a return to the old days of concentrated, mutually owned market structure, perhaps with added government oversight. However, such structure carries moral hazard that invites excessive risk-taking under the pretense that a 'liquidity mandate' provides a bail out mechanism for bad trades. Moreover, regulation would create entry barriers to entrepreneurs with prospective game-changing innovations, thereby shielding incumbent marketplaces from competitive pressure.

Rick Santelli, on the other hand, proposes a free market solution. If the current market structure is not attractive to particular customers, then those customers don't have to participate. This is already occurring. Retail and institutional investors comprise smaller and smaller fractions of order flow.

If (big if) regulations and other entry barriers do not impair the development of alternative exchanges that could serve these customers better, then supply will follow demand.