Jim Grant: What Henry Hazlitt Can Teach Us About Inflation In 2014

Submitted by James Grant via The Ludwig von Mises Institute,

This article is adapted from a portion of the Henry Hazlitt Memorial Lecture, delivered at the 2014 Austrian Economics Research Conference by James Grant.

Believe me, ladies and gentlemen, when you stand at the pinnacle of financial journalism, you’re standing at sea level. There are exceptions to the rule, of course. The Victorian polymath Walter Bagehot, second editor of The Economist, was one. The twentieth century Americans Garet Garrett, John Chamberlain and — my old mentor at Barron’s — Robert M. Bleiberg were others. Each brought something extraordinary to the prosaic business of financial and economic reporting and commentary. Then there was Henry Hazlitt (1894-1991), author, critic, self-taught economist and visionary. I stand before you in the reflected glory of his reputation.

The author of Economics in One Lesson, a longtime columnist for Newsweek and an editorial writer for The New York Times in the distant, pre-Krugman era, Hazlitt waged a career-long battle against inflation. He was at it in 1946 — and he was still going strong in 1966. It may be well at this point to define terms — Hazlitt would have certainly wanted us to.

You have heard inflation reduced to the phrase, “too much money chasing too few goods.” It is an overly narrow definition. Inflation is too much money. What the redundant increment of purchasing power chooses to chase is variable but always mischievous. It varies from cycle to cycle.

In one market interval, the dollars may chase skirts — or toothpaste or automobiles. This is inflation at the checkout counter, the familiar CPI variety. Or the dollars may chase stocks — or bonds or Iowa farmland. On Wall Street, where I work, this is the kind of inflation known as a “bull market,” and most of us cheer it on. The inflation of asset values is the kind of inflation that is prevalent today.

In the past year, the world’s central banks have materialized — net — $1.9 trillion (net, for instance, of the substantial shrinkage of euros effected by the European Central Bank). They conjured it on their computer keyboards. It may help to grasp the meaning of this vast pile of scrip to note that it is more than the GDP of India. One hears constantly that these central bank effusions are merely helping us adjust to the “new normal.” I dispute it — and I’m sure that Henry Hazlitt would dispute it if he were here today.

“Deflation,” too, is a perennially misunderstood term. It is not — as one so often hears it defined — a simple decline in aggregate prices. Let’s try a mind experiment. Suppose you lived in a time of material and technological wonder: of digital technology that sets robots to work, makes universally accessible the canon of human knowledge (and, to be sure, of human error) and coordinates and arbitrages the world’s far-flung labor markets. As it costs less to make things, so it should cost less to buy them.

Would you call this happy state of affairs “deflation” — or might you call it “progress”? Most Americans seem to not to mind it, whatever the Federal Reserve chooses to call it. They spend half their weekends looking for it.

With this in mind, let’s hear from Hazlitt himself, master of economic clarity. Here he is in June 1946 — in the New York Times, no less — taking the government to task for its misplaced worry about a return to the 1930s.

“A Washington correspondent of the Wall Street Journal reports that the government economic experts are now convinced the ‘deflation’ and not inflation will be the big problem six months to a year from now,” Hazlitt began. “Planners of federal financial policy make no secret of their belief that the danger of post-war inflation was passed in late spring, and that from now on the greater danger lies in too-rapid deflation. Such a belief on the part of the government planners in Washington would not be surprising, the whole economic philosophy they have adopted leads them to believe that ‘the real danger is deflation,’ whatever the evidence may be on the other side.”

In 1946, as now, the government held up the threat of deflation to justify a policy of ultra-low low interest rates and easy money. Now ladies, and gentlemen, I have devoted thirty-one years of my life to writing about interest rates, and I have to tell you that I can’t see them anymore. They’re tiny. And so they were in 1946. Then, as now, the Fed had been conscripted into the government’s financial service. Just as it does today, the central bank pushed money-market interest rates virtually to zero and longer-dated Treasury securities to less than 3 percent. Just as it does today, the Fed had its thumb on the scales of finance.

Hazlitt urged the government to remove it:

“When interest rates are kept arbitrarily low by government policy, the effect must be inflationary,” he wrote. “In the first place, interest rates cannot be kept artificially low, except by inflation. The real or natural rate of interest is the rate that would be established if the supply and demand for real capital were in equilibrium. The actual money interest rate can only be kept below the natural rate by pumping new money into the economic system. This new money and new credit add to the apparent supply of new capital just as the judicious addition of water add to the apparent supply of real milk.”

Hazlitt concluded that “the money rate of interest can be kept below the real rate of interest only as long as the supply of new money exceeds the supply of new real capital. Excessively low interest rates are inflationary in the second place because they give an excessive stimulation to the volume of borrowing.”

Why, I could quote those perfectly formed sentences in Grant’s today (and I believe I just might). They’re as timely now as they were during the administration of Harry S. Truman. The effective federal funds rate has been zero for well nigh six years.

There is a doctrine in finance called the dividend discount model. It says that the price of a common stock is the present value of its future cash flows discounted by a suitable rate of interest. Now what would happen to the calculation of the value of that stock if the rate of interest were unsuitable — if it were artificial?

Hazlitt says this: “Excessively low interest rates are inflationary because they mean that bonds, stocks, real estate and unincorporated businesses are capitalized at excessively high rates, and will fall in value even though the annual income they pay remains the same, if interest rates rise.”

If interest rates were artificially low, it would follow that prevailing investment values are artificially high. I contend that they are, and you may or may not agree. But you must allow the observation that we live in a kind of valuation hall of mirrors. We don’t exactly know where our markets should trade, because we don’t know where interest rates would be in the absence of central-bank manipulation. Natural interest rates — free-range, organic, sustainable — are what we need. Hot-house interest rates — the government’s puny, genetically modified kind — are the ones we have.

Hazlitt understood the effects of these intrusions in the market. More than that, he was able to explain them in words so simple, yet so elegant, that the proverbial milkman in Dayton could follow his argument. What a remarkable man was he, and how well it would suit us all to live more closely to his example.




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A Visual Trip Through The World’s Mining Ghost Towns

As each of the following seven towns from history around the world boomed on the back of resource-hungry bubbles, no one could have foreseen (or even believed) that it would ever end… but as the following dismal images show – end it did. Is this the future for North Dakota or Texas? or Silicon Valley? (of course not stupid… it’s different this time).

 

Via The Wall Street Journal,

Although many small mining towns survive commodity-market downturns, some simply fold up when prices fall or their resources are exhausted. A few of the world’s best-known mining ghost towns:

KOLMANSKOP, Sperrgebiet, Namibia

German migrants built stately homes, a casino and Africa’s first tram after diamonds were discovered in 1908 in this part of the Namib desert. By the 1950s, discoveries dried up and the town was abandoned. Photo: A view from the town hospital.

BODIE, California, U.S.

This town grew to as many as 10,000 residents after gold was discovered in 1859, and at its peak it reportedly had 65 saloons. Reserves dwindled and the town was nearly deserted by 1915. It was designated a state park in the 1950s; some houses remained with their furniture kept in place. Photo: The Swazey Hotel at Bodie State Historical Park.

SEWELL, Cachapoal Province, Chile

Sewell was built high in the Andes mountains in 1905 to house workers at El Teniente, at one point the world’s largest underground copper mine. In the 1960s, the town had about 15,000 people, but they eventually left due to the difficult terrain. Abandoned in 1980, Sewell is now a Unesco World Heritage site. Photo: Sewell and El Teniente.

HASHIMA ISLAND, Nagasaki prefecture, Japan

Nicknamed ‘Gunkanjima’ (Battleship Island), this coal-mining center, established in the 1880s, was once said to be the most densely populated place on Earth. But after peaking at more than 5,000 in 1959, its population declined in the 1960s as investors lost interest in coal. The mine closed in the 1970s but reopened in 2009 for tours—and inspired scenes in the James Bond film ‘Skyfall.’ Photo: Ruins of the general office.

SILVERTON, New South Wales, Australia

Set in a deposit of silver, zinc and lead, Silverton took root in 1883 when a post office was built. Soon the population was about 3,000—but before the 1880s were out residents were already leaving to mine larger deposits nearby. Silverton even lost some of its buildings, moved by donkeys or camels. Today there are just a handful of structures left, along with about 50 residents. Photo: An old church at Silverton.

GILMAN, Colorado, U.S.

Sitting atop the Eagle Mine, where gold and silver were discovered in the late 1870s, followed by lead and zinc, Gilman was abandoned in the 1980s due to weak metal prices. The area was designated a Superfund clean-up site by the Environmental Protection Agency for the dangerous tailings left by the mining operations.

BARKERVILLE, British Columbia, Canada

A town rapidly sprouted here in the 1860s after a gold discovery, but after peaking at 4,600 in the middle of that decade, the population slowly declined as easy-to-find deposits were depleted. After another minor boom in the 1930s that lasted until World War II, the decline resumed, and in 1958 Barkerville was designated a heritage site, complete with people in period costumes demonstrating the history to visitors.

*  *  *

Booms inevitably lead to busts… especially in an entirely centrally planned world in which we live…  As Taleb noted,

It is both mis-guided and dangerous to push unobserved risks further into the statistical tails of the probability distribution of outcomes and allow these high-impact, low-probability “tail risks” to disappear from policymakers’ fields of observation.

 

What the world [will inevitably] witness is simply what happens when highly constrained systems explode.

 

As Jean-Jacques Rousseau put it, “A little bit of agitation gives motivation to the soul, and what really makes the species prosper is not peace so much as freedom.” With freedom comes some unpredictable fluctuation. This is one of life’s packages: there is no freedom without noise—and no stability without volatility.




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Jobs Friday: What The Bubblevision Revelers Missed

Submitted by David Stockman via Contra Corner blog,

Yes, the nonfarm payroll clocked in at 138.5 million jobs and thereby retraced for the first time the point at which it stood 77 months ago in December 2007. This predictably elicited another “milestone of progress” squeal from the mainstream media.

So you have to wonder. Did these people skip history class? Do they understand the vital idea of “context”? Are they so mesmerized by paint-by-the-numbers agit prop from Wall Street and Washington that they have come to mindlessly embrace the notion that any number that is better than the last “print” is all that it takes—regardless of composition, quality or longer-term trend?

Thus, consider the ancient days of the Reagan era. Back then there were actually 15.0 million new jobs by the time that 77 months had elapsed after the June 1982 bottom. And these were honest-to-goodness new jobs that had never before existed, not born again jobs of the type that CNBC has made a “jobs Friday” fetish out of ever since the Great Recession was officially declared over in June 2009.

So if you want to try a little “context” absurdity recall this. So far we have created a trifling 100k “new” jobs since the last cyclical peak. During the equivalent 77 months in the Reagan era the US economy actually generated 150 times more jobs!

And, no, that wasn’t due to a demographic windfall of new employable bodies. During that 77 month period the civilian population age 16 and over increased by 8% or 13.3 million. This means that 113% of the growth in the pool of employable adults was converted into job-holders.

This time around, the pool of working age adults grew by quite respectable 14.4 million; and that amounted to a not shabby gain of 6% from December 2007. But self-evidently, during the 77 months since then virtually zero percent of the labor pool growth was converted into job holders. So the yawning difference between the Reagan era and now is not a surfeit of demography, but a dearth of job creation.

And this has nothing to do with Ronald Reagan hagiography—since the jobs gains of the 1980s were purchased in part with grotesque peacetime deficits of a magnitude never seen previously. Nor would they be seen again until the Bush-Obama era showed what real fiscal profligacy looks like.

But the larger point is that each cycle since the 1980s has generated net new jobs, albeit at a steadily declining rate. The truth of the matter is that we have now reached the point where no new payroll jobs have appeared for 77 months—which is to say, over the entire span of a historically ordinary peak-to-peak business cycle. Rather than a cause for celebration, therefore, the Friday jobs print ought to stand out as a wake-up call.

Surely, the CNBC revelers do not believe the business cycle has been abolished. And if not, why should it be assumed to have a indefinite remaining lease on life when everywhere around the world governments are at the end of their fiscal rope and central banks have painted themselves into an impossible monetary corner of ZIRP and QE. Is it not  probable that something will go bump-in-the-night owing to these vast experiments in fiscal and monetary largesse?

Stated differently, 6-years of ZIRP have left the world’s financial system booby-trapped with tottering pyramids of debt and rampant carry trades and financial speculations. Why would this be assumed to comprise the kind of stable and productive financial environment that would enable the current  business cycle expansion to go on for years into the future, thereby eclipsing every record from far more stable times of decades past?

So a 77 month jobs drought is a big deal, yet search the financial press and you will find no mention. And not just because of the benchmark set in the Reagan era.  During the 77 months after the 1990 peak nearly 10 million net jobs were created; the working age population expanded by 12.2 million; and the conversion rate was not zero, as during the recent go round, but actually more than 80%.

Even after the dotcom bust and well into the second Greenspan money pumping spree the US economy did manage to eke-out 5 million net nonfarm job gains during the 77 month interval after the 2001 peak.  And that amounted to a 28% conversion rate from the 18 million gain in the working age population pool.

Taken in broader context, however, the two most recent cycles of first middling job growth during the Greenspan housing bubble and then zero growth during the entire duration of Bernanke’s ZIRP experiment constitute an alarm bell of secular import. After all, since January 2000—when Bill Clinton was enjoying his last days in the Oval Office—the US economy has created only 7.5 million net nonfarm payroll jobs. That amounts to less than 45,000 per month or not even 30 percent of the monthly growth in the pool of the working age population.

That comparison alone points to a up-coming crisis, but not one of the type imagined by the stock market cheerleaders on bubblevision. The crisis that we are drifting into owing to the failure of meaningful economic growth and job creation during this century is one of fiscal dependency.

It implies a crisis of public finance that will either lead to continued bond-buying by the Fed and an eventual monetary collapse, or, in the alternative, decades of steadily rising taxes–likely of the wealth destroying populist kind—that will shutdown the American economy and render Washington even more paralyzed, ineffectual and rent with partisan conflict than it is today.

The numbers behind that proposition are dispositive. Owing to the lack of job creation since the turn of the century, the number of Americans over 16-years who are not employed has soared, rising from 75 million to 102 million. And that massive gain in the ranks of non-workers is not because the entire baby-boom up and retired. In fact, there are only about 7 million more “retired” Americans on OASI today than there were 14 years ago.

So upwards of 20 million have tumbled into public and private safety nets. As to the former, the number of combined food stamp and social security disability recipients(DI)—the first line of the public safety net—has surged from 23 million in 2000 to in excess of 60 million today. So one-in-five citizens are already in the public safety net, and millions more have fallen on private support by moving in with mom and day, into public shelters or onto the streets.

And yet the clueless CNBC revelers apparently think that this is some kind of societal misfortune, but nothing which could cloud the perpetually bullish skies ahead. In the Keynesian world of 30 days at a time, in fact,  the predicate is just the opposite. That is, don’t even begin to address the implied fiscal crisis of jobless dependency because the resulting “fiscal drag” might shave a tenths off the quarterly GDP print.

In short, never in modern times has the financial press had its head buried so deeply in the sand. Counting “jobs” as if the principle of “one man, one vote” applied in the realm of economics should be indictment enough. It is not even possible that the revelers are aware of the following cardinal fact—a fact which belies part and parcel the farce known as jobs Friday.

During 2013 the private business sector—which once upon a time was thought of as the foundation of growth and wealth in the US economy—utilized 194 billion labor hours. What is salient about that fact is that it is the same number of labor hours as were utilized by the private business sector way back in the days of Bill Clinton’s blue dress period—that is, 1998.

So it is entirely fair to call people clueless who revel in 217,000 “new” jobs last month, while completely ignoring that this cyclical blip occurred in a context in which there has been no gain in the true metric of employment—-labor hours in the business sector—for 16 years running.

So this means that as the job count has crept upwards, the actually utilization of labor has gone nowhere during this entire century. Well, actually, utilization of the most productive and high paying labor has actually gone south. As shown below,  the number of goods producing jobs—construction, manufacturing and mining/energy—has actually shrunk big time.

Notwithstanding the Friday cross-over into aggregate job growth after 77 months, the number of goods producing jobs reported last Friday was 19.0 million or 3 million and nearly 15% fewer than in December 2007; and even more starkly, 4.6 million or 23% fewer than existed at the turn of the century.

Goods Producing Economy - Click to enlarge

Goods Producing Economy – Click to enlarge

While the fall has been less dramatic, the pattern is also true for what we have called core private sector services jobs—- distribution and transportation, FIRE (finance, insurance and real estate), information technology, the white collar professions, and business management and support services. At a posting of 38.6 million jobs on Friday, the print had still not reached its December 2007 level.

In fact, while these are the highest paying jobs in the US economy—with annualized pay rates around $50k—- the monthly rate of growth since January 2000 is just 9k jobs.

Likewise, the very highest paying jobs in the US economy—core government employment outside of education and the post office—where average pay rates exceed $60k per year, is also still below is 11.2 million level of December 2007.

To be sure, from a fiscal policy viewpoint, this is more than welcome, and there are millions more of these taxpayer funded jobs—especially the 800,000 in the Pentagon—that could be readily dispensed with. But that makes the “jobs count” game all the more ridiculous.

Taken together, the goods producing sector plus core private business services and government outside of education constitute the “breadwinner economy”. Average pay rates are upwards of $50K annually and in many areas of the country approximate the median household income and provide the basis to support a family. Yet at the Friday count of 68.6 million breadwinner jobs, were still 3.3 million jobs short of the December 2007 peak. In fact, there are 5% few breadwinner jobs today than there were in January 2000.

Breadwinner Economy - Click to enlarge

Breadwinner Economy – Click to enlarge

As shown below, on the margin these disappearing high wage breadwinner jobs are being replaced with part time gigs in bars, restaurants, retail and temp agencies where pay rates of $20K annualized are not even two-fifths of the level which pertains in the breadwinner economy.

Bread and Circuses Economy - Click to enlarge

Bread and Circuses Economy – Click to enlarge

Part Time Economy - Click to enlarge

Part Time Economy – Click to enlarge

Outside of the Part-Time economy the only other source of job growth during the last 77 months was in the HES Complex—health education and social services.  Here the Friday print of 31.6 million jobs was up by 2.4 million or 8% from the last cyclical peak.

But the problem here is two-fold. In the first instance, the nearly 32 million jobs in this sector pay only an average of 35K per year and are heavily dominated by low pay jobs in education, home health services, nursing homes and social welfare agencies.

But secondly, and more importantly, these jobs are overwhelmingly fiscally dependent. That is, funding of production and employment in the HES Complex  comes from local, state and Federal spending or through the back-door of some $300 billion in Federal tax expenditures for employer health plans and education tax credits.

Not surprisingly, as the fiscal noose continues to tighten, the rate of monthly jobs growth in the HES Complex has steadily eroded.  During the Greenpsan Bubble from 2000-2007, the jobs count expanded at 51k per month. But it then fell to 43K during the Great Recession and has clocked in at just 27K per month since June 2007.

At the present time, the number is being given a small boost by the inception of Obamacare, but at the end of the day the fact that the US has reached peak fiscal debt will over-ride all else.  Stated differently, it is surely a truism that we can’t borrow or tax our way into more jobs for the indefinite future. What has been America’s de facto jobs machine since the turn of the century has long ago seen its heyday.

HES Complex Jobs - Click to enlarge

HES Complex Jobs – Click to enlarge

What is left is the picture below. Namely, an economy that has not generated a single net new job for 14 years—outside of HES Complex—- jobs which were bought and paid for by taxpayers and the debts that have been created in their behalf.  Only in a world gone mad for Keynesian money printing and serial bubble finance could a knuckle head like Steve Leisman conclude that we are on the road to recovery because we got another favorable print on “jobs Friday”.

Nonfarm Payrolls Less HES Complex - Click to enlarge

Nonfarm Payrolls Less HES Complex – Click to enlarge




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Tonight on The Independents: Mark Hannah & Deneen Borelli on the Las Vegas Shooting & Hillary’s Poverty; Eli Lake on Bergdahl, Michael Malice on the New NoKo Prisoner, Dan Caldwell on the V.A., Plus Sexy After-Show

Scumbags |||Did the
cop-killing rampage
of Jerad and Amanda Miller
spring from everyday right-wing rhetoric
? Was it just the
latest
example of the “Constant cop-killing, by people who echo the NRA
talking points and the conspiracy theories of the Internet wackos”?
Did it show
how
 “Fox news has finally yelled fire in a crowded
theater”? Or is the political interpretation
a bit more complicated
than all that?

On tonight’s episode of The
Independents
(Fox Business Network, 9 p.m. ET, 6 p.m. PT,
repeats three hours later), we’ll start off with some debate on
that topic with Party Panelists Mark Hannah (former
Kerry/Obama aide) and Deneen Borelli, author of

Blacklash: How Obama and the Left Are Driving Americans to the
Government Plantation
. Those two are also slated
to discuss Hillary Clinton’s
heartbreaking poverty
, the GOP’s
$60 million initiative
to reach black voters, plus AirBnB’s
move into the
dinner-party market
.

Daily Beast national security reporter Eli Lake (read him in
Reason here)
will come on to discuss the latest news about
Bowe Bergdahl
. Known crazy person Michael Malice (read him in
Reason here)
will talk about the latest U.S. hostage situation: Ohio lawyer
Jeffrey Fowle, detained for the crime of
having a Bible in his hotel
. And Dan Caldwell, issue and
legislative campaign manager of Concerned Veterans for America,
will talk about
the latest V.A. audit
.

Aftershow begins on http://ift.tt/QYHXdy
a few moments after you say “AAAAGGGHHHH!!!” Follow The
Independents
on Facebook at http://ift.tt/QYHXdB,
follow on Twitter @ independentsFBN, tweet
like a bastidge during the show & we’ll use the best of ’em.
Click on this page
for more video of past segments.

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Japan Has “Inappropriately Omitted” 80 Bombs-Worth Of Nuclear Fuel In IAEA Report

We are sure it’s just an oversight… but given Abe’s increasingly nationalist banter (and an economy set to plunge in Q2 after Q1’s pre-tax-hike surge), it is certainly worth noting that, as The Japan Times reports, Japan failed to include 640 kg of unused plutonium in its annual reports to the International Atomic Energy Agency in 2012 and 2013, in what experts are terming an “inappropriate omission.” The unreported amount is enough to make about 80 nuclear bombs. reassuringly, officials noted “there is no problem in terms of security against nuclear terrorism,” but as another pointed out, “should make efforts to improve” its reporting. Well, yeah, especially given that Japan possesses the largest amount of plutonium among nonnuclear weaponized nations.

As The Japan Times reports,

Japan failed to include 640 kg of unused plutonium in its annual reports to the International Atomic Energy Agency in 2012 and 2013, in what experts are terming an “inappropriate omission.”

 

The stock is part of mixed plutonium-uranium oxide (MOX) fuel stored in a reactor that was offline during this period, and was thus deemed exempt from IAEA reporting requirements, said an official at the Japan Atomic Energy Commission.

 

Experts warn that Japan’s reporting does not reflect the actual state of unused plutonium that could be diverted for nuclear weapons. The unreported amount is enough to make about 80 nuclear bombs.

But don’t worry…

The official said, “There is also no problem in terms of security against nuclear terrorism.”

It seems the IAEA is a little concerned…

From the safeguards point of view, this material is still unirradiated fresh MOX fuel regardless of its location,” former IAEA Deputy Director General Olli Heinonen said. “If it has indeed not been irradiated, this should be reflected in the statements.”

 

 

In March 2011, the MOX fuel was loaded into the No. 3 reactor of Kyushu Electric Power Co.’s Genkai nuclear plant in Saga Prefecture during a regular checkup. It was removed two years later because the reactor has remained idled since the Fukushima nuclear crisis.

 

When Japan reported to the IAEA in 2012 that it had 1.6 tons of unused plutonium at reactors nationwide as of the end of 2011, down from 2.2 tons the previous year, it excluded the 640 kg. The amount reported a year later remained at 1.6 tons.

 

The fuel has been kept unused in a fuel pool since March 2013.

Why worry…

Japan is subject to rigorous international monitoring, as it possesses the largest amount of plutonium among nonnuclear weaponized nations, with more than 44 tons extracted from spent fuel and reprocessed for reuse under its nuclear fuel cycle policy.




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3 Ways to Not Screw Up Marijuana Legalization

After the end of prohibition, many states put a
great deal of regulation in place to control alcohol. Even today,
some
microbreweries can’t
legally sell you a pint of their own beer
because of these regulations. And in states such as Pennsylvania
and Virginia, consumers still have to go to state-run, Soviet-like
package stores to buy booze.

Now that marijuana legalization is underway in America, there
are a number of lessons that can be learned from the end of alcohol
prohibition. Reason TV highlights three of these
takeaways. 

View this article.

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Risk Analysis In The Golden Age Of The Central Banker

Submitted by Ben Hunt via Salient Partners Epsilon Theory blog,

When I was a little kid we had a sand box. It was a quicksand box. I was an only child … eventually.
Steven Wright

A brief note today on what might be an arcane subject for some but is a great example of the most basic question in risk management – are you thinking about your risk questions in a way that fits the fundamental nature of your data? Do you understand the fundamental nature of your data? Our business incentivizes us to build complex and ingenious models and data analysis systems in order to generate an edge or dodge a bullet. But are we building our elaborate mental constructs on solid ground? Or on quicksand?

I’ve spent a lot of time recently talking with clients about measuring market risk across a wide range of asset classes and securities as part of an adaptive investment strategy, and I get a lot of smart questions. One of the best was deceptively simple – what do you think about using implied volatility to measure risk? – and that’s the question I want to use to illustrate a larger point.

First let’s unpack the question. Volatility is a measurement of how violently the returns of a security jump around, and in professional investment circles the word “volatility” is typically used as shorthand for risk – the higher the volatility, the greater the embedded risk. There are some valid concerns and exceptions to this conflation of the two concepts, but by and large I think it’s a very useful connection.

Within the general concept of volatility there are two basic ways of measuring it. You can look backwards at historical prices over some time period to figure out how violently those prices actually jumped around – what’s called “realized volatility” – or you can look forward at option prices for that same security and figure out how violently investors expect that prices will jump around in the future – what’s called “implied volatility”. Both flavors of volatility have important uses, even though they mean something quite different. For example, a beta measurement (how much a security’s price moves relative to an underlying index) is based on realized volatility. On the other hand, the VIX index – the most commonly reported gauge of overall market risk or complacency – is entirely based on the implied volatility of short to medium-term options on the S&P 500.

The big drawback to using realized or historical volatility is that it is, by nature, backwards looking. It tells you exactly where you’ve been, but only by extrapolation provides a signal for where you are going. In a business where you always want to be looking forward, this is a problem. Using realized volatility means that you will always be reacting to changes in the broad market characteristics of your portfolio; you will never be proactive to looming changes that might well be embedded within the “wisdom of the crowd” as found in forward-looking options prices. If you’re relying on realized volatility, no matter how sensitively or smartly you set the timing parameters, you will always be late. This was the point of the smart question I was asked: isn’t there useful information in the risk expectations of market participants, information that allows you to be proactive rather than reactive … and shouldn’t you be using that information as you seek to balance risk across your portfolio?

My answer: yes … and no. Yes, there is useful information in implied volatility for many purposes. But no, not for the purpose of asset allocation. Why not? Because we are living in the Golden Age of Central Bankers, and that wreaks havoc on the fundamental nature of market expectations data.

Here’s an example I’ve used before to illustrate this point, courtesy of Ed Tom and the Credit Suisse derivatives strategy group. Figures 1 shows the term structure (implied price level at different future times based on prices paid for options) of the VIX index on October 15th, 2012.


Figure 1: 8-Month Forward VIX Term Structure

If you recall, there was great consternation regarding the Fiscal Cliff at this time, not to mention the uncertainty surrounding the November elections. That consternation and uncertainty is reflected in the term structure, as it is much steeper than is typical for a spot VIX level of 15, indicating that the market is anticipating S&P 500 volatility to be progressively higher to an unusual degree from January 2013 onwards. The way to read this chart is that the market expects a VIX level of 18 three months in the future (January 15), 19 three and a half months in the future (January 31), 20 four months in the future (February 15), and so on. All of these results are higher than one would typically expect for future expectations of the VIX from this starting point (essentially flat at 17).

Now take a look at Figure 2, which shows the Credit Suisse estimation of the underlying distribution of VIX expectations for January 31, 2013.


Figure 2: January 31, 2013 Forward Estimated VIX Exposures

The way to read this chart is that a lot of market participants have a Bullish view (low VIX) for what the world will look like on January 31, with a peak frequency (greatest number of bullish contracts) at 15 and a fairly narrow distribution of expectations around that. Another group of market participants clearly have a Bearish view (high VIX) of the world on January 31, with a peak frequency around 24 and a fairly broad distribution around that.

So what’s the problem? The problem is that Figure 1, which is what you would come up with based on public options data, says that the most likely implied price for the VIX on January 31, 2013 is 19. But Figure 2, which is based on the trading data that Credit Suisse collects, says that a VIX level of 19 is the least likely outcome. What Figure 2 tells you is that almost no one expects that the outcome will end up in the middle at a price of 19, even if that is the average implied price of all the exposures.

Usually the average implied price of a security is also the most likely estimated price outcome of the security. That is, if options on a security imply an average price of 19 a few months from now, exposures will generally form some sort of bell curve centered on the price of 19. The most common estimation of the price would be 19, with fewer people estimating a higher price and fewer people estimating a lower price. But in those situations – like expectations of future VIX levels on October 15, 2012 – where there’s not a single-peaked distribution, all of our math and all of our models and all of our intuitively held assumptions go right out the window.

Unfortunately, these bi-modal market expectation structures are now the rule rather than the exception in this, the Golden Age of the Central Banker. Why? Because monetary policy since March, 2009 has explicitly established itself as an emergency bridge for financial markets, a bridge between the real world of an anemic, under-employed, under-utilized economy and the hoped-for world of a vibrantly growing, robust economy. On its own terms, this has been an entirely successful experiment, I suspect surpassing the wildest dreams of Bernanke et al. Stock markets have been “bridged”, reflecting what the world would look like if the global economy were off to the races, while bond markets reflect what the world actually looks like with the global economy sputtering in fits and starts. The problem today is that the experiment has been too successful. Whether you are in Europe or the US or Japan or China or wherever, the only investment questions that matter are whether central banks will continue their emergency monetary policies and what happens if the bridges are removed. These are not small, incremental policy questions. These are existential questions, reflecting binary expectations of the world with an enormous chasm in-between. With a hat tip to Milton Friedman, we are all bi-modal now.

So what’s the moral of this story for portfolio management? There are four, I believe.

In the Golden Age of the Central Banker …

1) the VIX is not a reliable measure of market complacency. Remember that the VIX itself is an implied volatility construct, built on the prices paid for options on the S&P 500 two to three months in the future. We assume that whatever the VIX is reported to be, that’s the consensus market expectation, with a lot of people holding that particular view and progressively fewer people on either side of that number. This is not necessarily the case, and when binary events raise their ugly heads it is almost certainly not the case. A low VIX level might indicate a complacent market, or it might indicate two sets of investors – one very complacent and one non-complacent – who see the world entirely differently. You have no idea what the underlying market expectations look like, and this makes all the difference in determining what the VIX means.

2) the wisdom of crowds is nonexistent. I believe in the efficiency of emergent behaviors. I believe that there is a logical dynamic process to crowd behaviors. But I also believe that crowds are extremely malleable when confronted by powerful individuals or institutions that understand the strategic interaction of crowds and make a concerted effort to master the game. There’s no inherent “wisdom” here, no emergent outcome where the crowd acts like an enormous set of parallel microprocessors to arrive at Truth with a capital T. The Common Knowledge Game is controlled by the Missionary, and our current Missionaries – central bankers, politicians, famous investors and media mouthpieces – know it.

3) fundamental risk/reward calculations for directional exposure to any security are problematic on anything other than a VERY long time horizon. Game-playing has always been a big part of the market environment, and it dominates successful directional bets on a very short time horizon. Similarly, stock-picking on a fundamental basis has always been a big part of the market environment and dominates successful directional bets on a very long time horizon. Between the very short-term and the very long-term you have this mish-mash of game-playing and stock-picking. One impact of the pervasiveness of the Common Knowledge Game today is that it pushes out the time horizon on which stock-picking on a fundamental basis can really shine. If you’re in the stock-picking business the value of permanent capital has never been greater.

4) I’d rather be reactive and right in my portfolio than proactive and wrong. I started this note with an acknowledgment of the weakness of risk assessments based on realized or historical volatility – it’s inherently backwards looking and you will always, no matter how finely calibrated your system, be late to respond to changing market conditions. But here’s the thing. This is what it means to be adaptive. You can’t be adaptive without something to adapt TO. Will you miss the market turns? Will you occasionally get whipsawed in your reactive process? Without a doubt. But you won’t get killed. You won’t be on the wrong side of a binary bet that you really didn’t need to make. You won’t discover that your pretty little sand box is really filled with quicksand. The Golden Age of the Central Banker is a time for survivors, not heroes. And that’s the real moral of this story.




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No Wonder Impeachment Was “Off the Table”: Democrats Approved Mass Surveillance and Torture … and the Subsequent Cover-Up

Pelosi Was Briefed On – and Covered Up – NSA Spying On Americans

When a teen asked Nancy Pelosi last week why she supports unconstitutional NSA spying, Pelosi responded that the NSA lied to Congress about what they were doing, and she didn’t know:

But Pelosi was actually briefed on – and approved – illegal mass surveillance by the NSA.

Last November, high-level NSA whistleblower Bill Binney confirmed to Washington’s Blog that Pelosi was briefed on NSA’s mass surveillance of Americans:

WASHINGTON’S BLOG: Is CBS right that you tried to warn Congress 10 years ago?

BILL BINNEY: Yes, first to Diane Roark (House senior staff assigned to monitor NSA) in late 2001, then, to a House Intel Committee member. Diane also talked to Porter Goss [then-chair of the House Intelligence Committee] and Nancy Pelosi [ranking member on the Intelligence Committee at the time] about it in the same time frame. This to me was the obvious reason Nancy said (when she was speaker) that impeaching George W was off the table. Cause she was part of it from the beginning.

Last week, Diane Roark confirmed that this was true:

WASHINGTON’S BLOG: Bill Binney explained in a recent interview that Pelosi refused to impeach Bush because she herself had signed off on mass NSA surveillance of Americans. Can you confirm Mr. Binney’s statement from your experience?

DIANE ROARK: Yes, Nancy Pelosi was one of the “gang of four” because she was the ranking Democrat on the House Intelligence Committee in 2001 and for some time after that. So she gave the go-ahead to the Administration along with the others.

She now claims that the administration withheld information from her. However, I sent her numerous memos updating her as I learned more and giving background on the system. I did this through her staff director, who assured me he had given them to her. Her office claimed to the New Yorker in 2011, however, that she had not received the memos.

See this for Roark’s explanation of what the mass surveillance is really about, and Congress’ refusal to demand accountability or controls.

Pelosi Also Complicit In Torture

Pelosi was also complicit in torture. And yet she lied about that, also.

Nancy Pelosi claimed in 2009:

The Bush administration did not inform Congress that it had waterboarded detainees in classified briefings, after the agency had already done so…

 

Pelosi told reporters that the administration officials only told her and those in a classified briefing in the fall of 2002 that they believed they had the legal authority to do so, based on Office of Legal Counsel memos which have recently been released by the Obama administration.

 

“In that or any other briefing…we were not, and I repeat, were not told that waterboarding or any of these other enhanced interrogation techniques were used,” said Pelosi. “What they did tell us is that they had some legislative counsel…opinions that they could be used, but not that they would.”

However, that is likely untrue.

As noted by the above-linked article at Huffington Post:

Her assertion contradicts a recently released Senate committee report that cited CIA records to claim that senior members of Congress in both parties were briefed on the waterboarding, which had already been done to detainee Abu Zubaydah.

Moreover, the Washington Post wrote in 2007:

Four members of Congress met in secret for a first look at a unique CIA program designed to wring vital information from reticent terrorism suspects in U.S. custody. For more than an hour, the bipartisan group, which included current House Speaker Nancy Pelosi (D-Calif.), was given a virtual tour of the CIA’s overseas detention sites and the harsh techniques interrogators had devised to try to make their prisoners talk.Among the techniques described, said two officials present, was waterboarding, a practice that years later would be condemned as torture by Democrats and some Republicans on Capitol Hill. But on that day, no objections were raised. Instead, at least two lawmakers in the room asked the CIA to push harder, two U.S. officials said.

 

“The briefer was specifically asked if the methods were tough enough,” said a U.S. official who witnessed the exchange…

 

The CIA gave key legislative overseers about 30 private briefings, some of which included descriptions of that technique and other harsh interrogation methods, according to interviews with multiple U.S. officials with firsthand knowledge. With one known exception, no formal objections were raised by the lawmakers briefed about the harsh methods during the two years in which waterboarding was employed, from 2002 to 2003, said Democrats and Republicans with direct knowledge of the matter. The lawmakers who held oversight roles during the period included Pelosi…

 

“Among those being briefed, there was a pretty full understanding of what the CIA was doing,” said Goss, who chaired the House intelligence committee from 1997 to 2004 and then served as CIA director from 2004 to 2006. “And the reaction in the room was not just approval, but encouragement.”…

 

Abu Zubaida, the first of the “high-value” detainees in CIA custody, was subjected to harsh interrogation methods beginning in spring 2002 after he refused to cooperate with questioners, the officials said. CIA briefers gave the four intelligence committee members limited information about Abu Zubaida’s detention in spring 2002, but offered a more detailed account of its interrogation practices in September of that year, said officials with direct knowledge of the briefings.

 

The CIA provided another briefing the following month, and then about 28 additional briefings over five years, said three U.S. officials with firsthand knowledge of the meetings. During these sessions, the agency provided information about the techniques it was using as well as the information it collected.

Other Top Dems Also Complicit

It’s not just Pelosi … top Democrats like Harman and Rockefeller also knew all about spying and torture, and approved … or at least covered it up.

Cover Up of 9/11 Torture and Unreliable Testimony

Veteran reporter Robert Scheer wrote in the San Francisco Chronicle in 2007 that Pelosi and Harman hid from the 9/11 Commission and the American people the fact that the interrogations of 9/11 suspects were videotaped, and that the alleged “confessions” of those held at Gitmo were wholly unreliable. They could have stopped the whole farce cold — but chose to go along with it.

By way of background, the CIA’s torture program ended up deceiving the 9/11 Commission. Specifically, the 9/11 Commission Report was largely based on third-hand accounts of what tortured detainees said, with two of the three parties in the communication being government employees. The 9/11 Commissioners were not allowed to speak with the detainees, or even their interrogators. Instead, they got their information third-hand. The Commission itself didn’t really trust the interrogation testimony… yet published it as if it were Gospel.

New York Times investigative reporter Philip Shenon Newsweek noted in a 2009 essay in Newsweek that the 9/11 Commission Report was unreliable because most of the information was based on the statements of tortured detainees.

As NBC News reported:

  • Much of the 9/11 Commission Report was based upon the testimony of people who were tortured
  • At least four of the people whose interrogation figured in the 9/11 Commission Report have claimed that they told interrogators information as a way to stop being “tortured.”
  • One of the Commission’s main sources of information was tortured until he agreed to sign a confession that he was NOT EVEN ALLOWED TO READ
  • The 9/11 Commission itself doubted the accuracy of the torture confessions, and yet kept their doubts to themselves

Indeed, the type of torture used by the U.S. on the Guantanamo suspects was of a “special” type. Senator Levin revealed that the the U.S. used Communist torture techniques specifically aimed at creating false confessions. And see these important reports from McClatchy, New York Times, CNN and Huffington Post.

No Wonder Impeachment Was “Off the Table”

No wonder Democrats “took impeachment off the table.” They were wholly complicit in Bush and Cheney’s crimes.




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Across America, Police Departments Are Quietly Preparing For War

At first blush, the title of this post could be perceived as somewhat hyperbolic by those who still have an impression of America’s police departments as bastions of safety, designed “to protect and to serve” the population of the “land of the free.” However, said impression would be promptly washed away upon reading an article in today’s NYT which citing Pentagon data, reveals that under the Obama administration, “police departments have received tens of thousands of machine guns; nearly 200,000 ammunition magazines; thousands of pieces of camouflage and night-vision equipment; and hundreds of silencers, armored cars and aircraft.

Which begs the question: just who is America’s police force, and by extension the Obama administration, which is behind this quiet militarization of local police forces with weapons that would normally be seen in a warzone, preparing for war against?

And while we already documented America’s conversation to a turnkey totalitarian banana republic (confirmed months later by Edward Snowden) below behold America’s conversion to a police state:

In the past we have occasionally covered the slow (but sure) conversion of America’s Police force into an army, fully loaded with the latest weapons and equipments, not even we had an idea of the full extent of what was going on behind the scenes. As the NYT describes, all of the above-mentioned equipment “has been added to the armories of police departments that already look and act like military units. Police SWAT teams are now deployed tens of thousands of times each year, increasingly for routine jobs. Masked, heavily armed police officers in Louisiana raided a nightclub in 2006 as part of a liquor inspection. In Florida in 2010, officers in SWAT gear and with guns drawn carried out raids on barbershops that mostly led only to charges of “barbering without a license.

Surely in an age when the NSA managed to eradicated all terrorism (oh oops, Boston bombing, we forgot, just ignore that), the mantra that a “weapon unused is a useless weapon” has never rang more true, but dispatching crack police team to handle rogue “barbers”? Sadly, that may be just a harbinger of the crackdowns the US police state will unleash shortly on anyone even the least bit guilty of violating some law or regulation. Or maybe completely innocent, just guilty of sparking the USPD’s curiosity. 

Meet the new normal SWAT: new, improved and, well, everywhere:

The number of SWAT teams has skyrocketed since the 1980s, according to studies by Peter B. Kraska, an Eastern Kentucky University professor who has been researching the issue for decades…. The ubiquity of SWAT teams has changed not only the way officers look, but also the way departments view themselves. Recruiting videos feature clips of officers storming into homes with smoke grenades and firing automatic weapons. In Springdale, Ark., a police recruiting video is dominated by SWAT clips, including officers throwing a flash grenade into a house and creeping through a field in camouflage.

The rationale for the weaponization of the US police force is simple: it’s yours if you want it. Also, it’s free.

The Pentagon program does not push equipment onto local departments. The pace of transfers depends on how much unneeded equipment the military has, and how much the police request. Equipment that goes unclaimed typically is destroyed. So police chiefs say their choice is often easy: Ask for free equipment that would otherwise be scrapped, or look for money in their budgets to prepare for an unlikely scenario. Most people understand, police officers say.

In the meantime, this is where the build up has come from…

Congress created the military-transfer program in the early 1990s, when violent crime plagued America’s cities and the police felt outgunned by drug gangs. Today, crime has fallen to its lowest levels in a generation, the wars have wound down, and despite current fears, the number of domestic terrorist attacks has declined sharply from the 1960s and 1970s.

 

Police departments, though, are adding more firepower and military gear than ever. Some, especially in larger cities, have used federal grant money to buy armored cars and other tactical gear. And the free surplus program remains a favorite of many police chiefs who say they could otherwise not afford such equipment. Chief Wilkinson said he expects the police to use the new truck rarely, when the department’s SWAT team faces an armed standoff or serves a warrant on someone believed to be dangerous.

 

Today, Chief Wilkinson said, the police are trained to move in and save lives during a shooting or standoff, in contrast to a generation ago — before the Columbine High School massacre and others that followed it — when they responded by setting up a perimeter and either negotiating with, or waiting out, the suspect.

… and where it is going.

In South Carolina, the Richland County Sheriff’s Department’s website features its SWAT team, dressed in black with guns drawn, flanking an armored vehicle that looks like a tank and has a mounted .50-caliber gun. Capt. Chris Cowan, a department spokesman, said the vehicle “allows the department to stay in step with the criminals who are arming themselves more heavily every day.” He said police officers had taken it to schools and community events, where it was a conversation starter.

 

Not everyone agrees that there is a need for such vehicles. Ronald E. Teachman, the police chief in South Bend, Ind., said he decided not to request a mine-resistant vehicle for his city. “I go to schools,” he said. “But I bring ‘Green Eggs and Ham.’ ”

The people are said to believe the explanation:

When you explain that you’re preparing for something that may never happen, they get it,” said Capt. Tiger Parsons of the Buchanan County Sheriff’s Office in northwest Missouri, which recently received a mine-resistant truck.

You mean like the Fed stepping back from propping the global capital markets? Or like Caesar taking over Rome and only then handing over the power to the people?

But however you explain it and whatever you call it, don’t call it overkill, no pun intended. Actually call it overkill.

Pentagon data suggest how the police are arming themselves for such worst-case scenarios. Since 2006, the police in six states have received magazines that carry 100 rounds of M-16 ammunition, allowing officers to fire continuously for three times longer than normal. Twenty-two states obtained equipment to detect buried land mines.

 

In the Indianapolis suburbs, officers said they needed a mine-resistant vehicle to protect against a possible attack by veterans returning from war.

 

“You have a lot of people who are coming out of the military that have the ability and knowledge to build I.E.D.’s and to defeat law enforcement techniques,” Sgt. Dan Downing of the Morgan County Sheriff’s Department told the local Fox affiliate, referring to improvised explosive devices, or homemade bombs. Sergeant Downing did not return a message seeking comment.

 

The police in 38 states have received silencers, which soldiers use to muffle gunfire during raids and sniper attacks. Lauren Wild, the sheriff in rural Walsh County, N.D., said he saw no need for silencers. When told he had 40 of them for his county of 11,000 people, Sheriff Wild confirmed it with a colleague and said he would look into it. “I don’t recall approving them,” he said.

Funny how that happens. Because that’s the whole point: if the police department is there to protect the people, shouldn’t the people decide how the police is armed? Apparently not. Then again, the light bulb did go over some heads.

At the Neenah City Council, Mr. Pollnow is pushing for a requirement that the council vote on all equipment transfers. When he asks about the need for military equipment, he said the answer is always the same: It protects police officers.

 

“Who’s going to be against that? You’re against the police coming home safe at night?” he said. “But you can always present a worst-case scenario. You can use that as a framework to get anything.”

 

Chief Wilkinson said he was not interested in militarizing Neenah. But officers are shot, even in small towns. If there were an affordable way to protect his people without the new truck, he would do it.

 

“I hate having our community divided over a law enforcement issue like this. But we are,” he said. “It drives me to my knees in prayer for the safety of this community every day. And it convinced me that this was the right thing for our community.”

Great, absolutely. Now just open it up for a vote and le the community itself decide!

Which brings us back to the original question: as the NYT succinctly summarizes the situation, “as President Obama ushers in the end of what he called America’s “long season of war,” the former tools of combat — M-16 rifles, grenade launchers, silencers and more — are ending up in local police departments, often with little public notice.”

 Perhaps that sentence needs some qualification: as Obama, humiliated on the international arena by everyone, from Assad to Putin and back, and desperately seeking to avoid future embarrassment, redeploys weapons of mass murder, why is he seeking to put said weapons – many of which are of the offensive kind – not out to pasture but in America’s very own back yard? Just who does Obama plan to wage his next, and hopefully last, war against? The good news is that everyone will get sufficient advance notice before said war begins by the squadrons of weaponized drones sent out to test the ground, and inflict the “accidental” collateral damage casualty, or million.




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