Month: September 2014

By: Chris Tell at http://ift.tt/146186R

Today’s article is compliments of our friend Mark Schumacher at ThinkGrowth. Mark has been a reader and subsequently become a regular bouncing board for us with respect to publicly traded equities, market sentiment and the like. I always value his thoughts and it is a rare occasion that we disagree. Enjoy!

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As our portfolio clients are well aware, we have been long the US dollar vs. the Japanese yen (USD/JPY) via a sizable position in YCS – purchased in the mid $40s – for almost two years beginning around the time Shinzo Abe was elected Prime Minister after running on his three arrows platform:

1. Monetary stimulus
2. Fiscal stimulus
3. Structural change

He promised large doses of each to invigorate the Japanese economy and I took him at his word knowing it meant a much weaker yen.

Arrow #3 WILL work but it is politically very difficult to implement as it requires near term pain during the adjustment phase to produce the positive long-term benefits of improved productivity and more efficient allocation of resources; labor and capital. Progress on arrow #3 has been dismal, and to my knowledge nothing significant is in the pipeline. I would not hold my breath on this one.

He has delivered on the first two arrows by inflating the money supply, lowering interest rates and expanding government budget deficits. The longer arrows #1 and #2 are implemented the weaker the yen and later JGBs (Japanese government bonds) will ultimately become. The hope is that the weaker yen will stimulate exports and somehow provide a net boost to the country even though Japan is a large importer especially of energy, commodities and labor-intensive manufactured components.

The theories and policies underlying arrows #1 and #2 are founded on fairy dust. It is an academic pipe dream to believe currency debasement and government debt are shortcuts to prosperity. Yet the dream lives on… not just in Japan either.

Post Abe’s election the USD/JPY exchange rate rapidly appreciated from the low 80s to the high 90s and we benefited nicely with YCS appreciating about $20 into the mid $60s. Since then the exchange rate has been in a narrow range with the yen losing some value and YCS being flat through the first eight months of this year.

However, post this consolidation period, it looks like a second round of yen weakness is now occurring and there appears to be an identifiable catalyst. Notice how YCS (a long USD short JPY fund) is moving sharply higher again in the two year chart below.

2-Year Chart of YCS

The Yen’s Second Wave of Weakness Begins

The catalyst for the next wave of yen weakness is the most recent release of Japanese economic data which was worse than expected. In Q2 the Japanese economy as measured by GDP shrank 7.1% due to a fall in both consumer spending and capital investments.

After 18 months of Abe’s massive monetary and fiscal stimulus the economy is not gaining meaningful traction to say the very least. I see this as another demonstration of how these policies cannot expand the size of the economic pie because they do not create wealth or economic prosperity, in fact, they destroy it by unnaturally skewing incentives and therefore behavior.

In a world run by rational minds, the weak Q2 data along with a string of other weak Japanese economic data would be an impetus to ditch arrows #1 and #2 and focus on #3 in which case there would be no compelling reason for us to be short the yen.

Rather than question the cause-and-effect assumptions underlying their monetary and fiscal policies in the face of a failure of results, policy makers almost always conclude that the problem was either the size or timing of their programs. This may be counter intuitive to your logical mind, but the longer Abe’s policies fail to deliver the hoped-for economic results, the more intensely they will be implemented… bad for Japan, good for our investment in YCS.

Expect more yen weakness over the coming year as the exchange rate heads back towards where it was pre-2008’s financial crisis.

15-Year Chart of USD vs. JPY

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As you can see, Mark is a sharp thinker. We have previously published some of his musings on portfolio diversification, buying out of favor stocks and market volatility, and I encourage you to read them.

– Chris

“Now, there is something called “Abenomics.” I didn’t coin the word. Markets did. It is the name given to my three-arrowed economic booster plan. Japan has been battling deflation for more than a decade. My plan, or “Abenomics,” is to put an end to that, first and foremost.” – Shinzo Abe

via Zero Hedge http://ift.tt/1D2mSlQ Capitalist Exploits

Submitted by Mike Krieger of Liberty Blitzkrieg blog,

Rudderless and without a compass, the American ship of state continues to drift, guns blazing.

 

– Andrew J. Bacevich, the Boston University political science professor and former Army colonel who lost his son in the Iraq war in 2007, in a recent Reuters article.

I have spent the past several days outlining my deep concerns about the “ISIS crisis” and Obama’s willingness to employ extreme propaganda in order to once again embark on another poorly thought out military campaign here and here. What I have also come to realize is that his latest war plan is brazenly illegal and unconstitutional.

While critics have been questioning the legality of U.S. military campaigns consistently since the end of World War II, one trend has become increasingly clear. With each new President and each new war, we have witnessed those who hold the office act more and more like dictators, and less and less like constitutional executives.

One very important, and up until recently, overlooked point about Obama’s latest “war on ISIS” is that this is not at all just more of the same. This crosses yet another very important line of shadiness, and if we as as American public allow him to do so, we will suffer grave long-term consequences to our economic future as well as our liberties. This is very serious stuff.

No one has outlined this point better than Bruce Ackerman, a professor of law and political science at Yale, in yesterday’s New York Times op-ed: Obama’s Betrayal of the Constitution. He writes:

BERLIN — PRESIDENT OBAMA’s declaration of war against the terrorist group known as the Islamic State in Iraq and Syria marks a decisive break in the American constitutional tradition. Nothing attempted by his predecessor, George W. Bush, remotely compares in imperial hubris.

 

Mr. Bush gained explicit congressional consent for his invasions of Afghanistan and Iraq. In contrast, the Obama administration has not even published a legal opinion attempting to justify the president’s assertion of unilateral war-making authority. This is because no serious opinion can be written.

 

This became clear when White House officials briefed reporters before Mr. Obama’s speech to the nation on Wednesday evening. They said a war against ISIS was justified by Congress’s authorization of force against Al Qaeda after the Sept. 11, 2001, attacks, and that no new approval was needed.

 

But the 2001 authorization for the use of military force does not apply here. That resolution — scaled back from what Mr. Bush initially wanted — extended only to nations and organizations that “planned, authorized, committed or aided” the 9/11 attacks.

 

Not only was ISIS created long after 2001, but Al Qaeda publicly disavowed it earlier this year. It is Al Qaeda’s competitor, not its affiliate.

 

Mr. Obama may rightly be frustrated by gridlock in Washington, but his assault on the rule of law is a devastating setback for our constitutional order. His refusal even to ask the Justice Department to provide a formal legal pretext for the war on ISIS is astonishing.

 

Senators and representatives aren’t eager to step up to the plate in October when, however they decide, their votes will alienate some constituents in November’s midterm elections. They would prefer to let the president plunge ahead and blame him later if things go wrong. But this is precisely why the War Powers Resolution sets up its 60-day deadline: It rightly insists that unless Congress is willing to stand up and be counted, the war is not worth fighting in the name of the American people.

 

But for now the president seems grimly determined to practice what Mr. Bush’s lawyers only preached. He is acting on the proposition that the president, in his capacity as commander in chief, has unilateral authority to declare war.

 

In taking this step, Mr. Obama is not only betraying the electoral majorities who twice voted him into office on his promise to end Bush-era abuses of executive authority. He is also betraying the Constitution he swore to uphold.

Think about this for a second. Barack Obama is using the 2001 Authorization for Use of Military Force (AUMF), which allowed for military action against “nations and organizations that planned, authorized, committed or aided the 9/11 attacks.” ISIS wasn’t even a twinkle in Abu Bakr al-Baghdadi’s eye back in September 2001. Even more stunning, ISIS and al-Qaeda more closely resemble enemies than allies. Yet this doesn’t seem to affect Nobel Peace Prize winning Barry Obama’s war planning. You can’t get much more insane and Orwellian than that.

Who cares right? This won’t ever affect you. So what if some bombs fall on innocent Arab civilians? Wrong.

One of the most terrifying aspects of this whole war push if Obama is able to pull it off, is that the reasoning (or lack thereof) could ultimately be applied to the detention of U.S. citizens indefinitely without a trial.

Yes, what I am referring to is the National Defense Authorization Act, or NDAA, which allows for the indefinite detention of American citizens without a trial. I covered this frequently several years ago when Chris Hedges and others were suing the Obama Administration regarding the constitutionality of this law. In fact, one of my most popular posts ever was, NDAA: The Most Important Lawsuit in American History that No One is Talking About.

One of the ways in which the U.S. government has defended the NDAA is by saying it can only be used against “a person who was a part of or substantially supported al-Qaeda, the Taliban, or associated forces that are engaged in hostilities against the United States or its coalition partners.” Glenn Greenwald noted in Salon in his, Three Myths About the Detention Bill, that:

Section 1021 of the NDAA governs, as its title says, “Authority of the Armed Forces to Detain Covered Persons Pursuant to the AUMF.”  The first provision — section (a) — explicitly “affirms that the authority of the President” under the AUMF  ”includes the authority for the Armed Forces of the United States to detain covered persons.” The next section, (b), defines “covered persons” — i.e., those who can be detained by the U.S. military — as “a person who was a part of or substantially supported al-Qaeda, the Taliban, or associated forces that are engaged in hostilities against the United States or its coalition partners.” 

Notice that the above says “pursuant to the AUMF,” which is the exact law the Obama Administration is using to justify his latest war. If he is able to start a war with ISIS based on the AUMF, despite the fact that ISIS and al-Qaeda are not allies at all, he or a future President could similarly use the AUMF and the NDAA to imprison anyone, anywhere for an indefinite amount of time based on the same absurd non-claim.

Let this all sink in for a second. Do you still support these ISIS strikes?

via Zero Hedge http://ift.tt/1rWKjof Tyler Durden

History did not end with the Cold War and, as Mark Twain put it, whilst history doesn’t repeat it often rhymes. As Alexander, Rome and Britain fell from their positions of absolute global dominance, so too has the US begun to slip. America’s global economic dominance has been declining since 1998, well before the Global Financial Crisis. A large part of this decline has actually had little to do with the actions of the US but rather with the unraveling of a century’s long economic anomaly. China has begun to return to the position in the global economy it occupied for millenia before the industrial revolution. Just as the dollar emerged to global reserve currency status as its economic might grew, so the chart below suggests the increasing push for de-dollarization across the 'rest of the isolated world' may be a smart bet…

As Deutsche Bank's Jim Reid explains,

In 1950 China’s share of the world’s population was 29%, its share of world economic output (on a PPP basis) was about 5% (Figure 98). By contrast the US was almost the reverse, with 8% of the world’s population the US commanded 28% of its economic output.

By 2008, China’s huge, centuries-long economic underperformance was well down the path of being overcome (Figure 97).

Based on current trends China’s economy will overtake America’s in purchasing power terms within the next few years. The US is now no longer the world’s sole economic superpower and indeed its share of world output (on a PPP basis) has slipped below the 20% level which we have seen was a useful sign historically of a single dominant economic superpower. In economic terms we already live in a bipolar world. Between them the US and China today control over a third of world output (on a PPP basis).

However as we have already highlighted, the relative size of a nation’s economy is not the only determinant of superpower status. There is a “geopolitical” multiplier that must be accounted for which can allow nations to outperform or underperform their economic power on the global geopolitical stage. We have discussed already how first the unwillingness of the US to engage with the rest of the world before WWII meant that on the world stage the US was not a superpower inspite of its huge economic advantage, and second how the ability and willingness of the USSR to sacrifice other goals in an effort to secure its superpower status allowed it to compete with the US for geopolitical power despite its much smaller economy. Looking at the world today it could be argued that the US continues to enjoy an outsized influence compared to the relative size of its economy, whilst geopolitically China underperforms its economy. To use the term we have developed through this piece, the US has a geopolitical multiplier greater then 1, whilst China’s is less than 1. Why?

On the US side, almost a century of economic dominance and half a century of superpower status has left its impression on the world. Power leaves a legacy. First the USA’s “soft power” remains largely unrivalled – US culture is ubiquitous (think McDonald’s, Hollywood and Ivy League universities), the biggest US businesses are global giants and America’s list of allies is unparalleled. Second the US President continues to carry the title of “leader of the free world” and America has remained committed to defending this world. Although more recently questions have begun to be asked (more later), the US has remained the only nation willing to lead intervention in an effort to support this “free world” order and its levels of military spending continues to dwarf that of the rest of the world. US military spending accounts for over 35% of the world total and her Allies make up another 25%.

In terms of Chinese geopolitical underperformance there are a number of plausible reasons why China continues to underperform its economy on the global stage. First and foremost is its list of priorities. China remains committed to domestic growth above all other concerns as, despite its recent progress, millions of China’s citizens continue to live in poverty. Thus so far it has been unwilling to sacrifice economic growth on the altar of global power. This is probably best reflected in the relative size of its military budget which in dollar terms is less than a third the size of Americas. Second China has not got the same level of soft power that the US wields. Chinese-style communism has not had the seductive draw that Soviet communism had and to date the rise of China has generally scared its neighbors rather then made allies of them. These factors probably help explain why in a geopolitical sense the US has by and large appeared to remain the world’s sole superpower and so, using the model of superpower dominance we have discussed, helps explain why global geopolitical tensions had remained relatively low, at least before the global financial crisis.

However there is a case to be made that this situation has changed in the past five or so years. Not only has China’s economy continued to grow far faster than America’s, perhaps more importantly it can be argued that the USA’s geopolitical multiplier has begun to fall, reducing the dominance of the US on the world stage and moving the world towards the type of balanced division of geopolitical power it has not seen since the end of the Cold War. If this is the case then it could be that the world is in the midst of a structural, not temporary, increase in geopolitical tensions.

Why do we suggest that the USA’s geopolitical multiplier, its ability to turn relative economic strength into geopolitical power, might be falling? Whilst there are many reasons why this might be the case, three stand out. First, since the GFC the US (and the West in general) has lost confidence. The apparent failure of laissez faire economics that the GFC represented combined with the USA’s weak economic recovery has left America less sure then it has been in at least a generation of its free market, democratic national model. As this uncertainty has grown, so America’s willingness to argue that the rest of the world should follow America’s model has waned. Second the Afghanistan and in particular the Iraq War have left the US far less willing to intervene across the world. One of the major lessons that the US seems to have taken away from the Iraq war is that it cannot solve all of the world’s problems and in fact will often make them worse. Third, the rise of intractable partisan politics in the US has left the American people with ever less faith in their government.

The net result of these changes in sentiment of the US people and its government has been the diminishment of its global geopolitical dominance. The events of the past 5+ years have underlined this. Looking at the four major geopolitical issues of this period we raised earlier – the outcome of the Arab Spring (most notably in Syria), the rise of the Islamic State, Russia’s actions in Ukraine and China’s regional maritime muscle flexing – the US has to a large extent been shown to be ineffective. President Obama walked away from his “red line” over the Syrian government’s use of chemical weapons. The US has ruled out significant intervention in Northern Iraq against the Islamic State.

America has been unable to restrain Pro-Russian action in Ukraine and took a long time (and the impetus of a tragic civilian airplane disaster) to persuade her allies to bring in what would generally be considered a “first response” to such a situation – economic sanctions. And so far the US has had no strategic response to China’s actions in the East and South China seas. Importantly these policy choices don’t necessarily just reflect the choice of the current Administration but rather they reflect the mood of the US people. In Pew’s 2013 poll on America’s Place in the World, a majority (52%) agreed that “the US should mind its own business internationally and let other countries get along the best they can on their own”. This percentage compares to a read of 20% in 1964, 41% in 1995 and 30% in 2002.

The geopolitical consequences of the diminishment of US global dominance

Each of these events has shown America’s unwillingness to take strong foreign policy action and certainly underlined its unwillingness to use force. America’s allies and enemies have looked on and taken note. America’s geopolitical multiplier has declined even as its relative economic strength has waned and the US has slipped backwards towards the rest of the pack of major world powers in terms of relative geopolitical power.

Throughout this piece we have looked to see what we can learn from history in trying to understand changes in the level of structural geopolitical tension in the world. We have in general argued that the broad sweep of world history suggests that the major driver of significant structural change in global levels of geopolitical tension has been the relative rise and fall of the world’s leading power. We have also suggested a number of important caveats to this view – chiefly that a dominant superpower only provides for structurally lower geopolitical tensions when it is itself internally stable. We have also sought to distinguish between a nation being an “economic” superpower (which we can broadly measure directly) and being a genuine “geopolitical” superpower (which we can’t). On this subject we have hypothesised that the level of a nations geopolitical power can roughly be estimated multiplying its relative economic power by a “geopolitical multiplier” which reflects that nations ability to amass and project force, its willingness to intervene in the affairs of the world and the extent of its “soft power”.

Given this analysis it strikes us that today we are in the midst of an extremely rare historical event – the relative decline of a world superpower. US global geopolitical dominance is on the wane – driven on the one hand by the historic rise of China from its disproportionate lows and on the other to a host of internal US issues, from a crisis of American confidence in the core of the US economic model to general war weariness. This is not to say that America’s position in the global system is on the brink of collapse. Far from it. The US will remain the greater of just two great powers for the foreseeable future as its “geopolitical multiplier”, boosted by its deeply embedded soft power and continuing commitment to the “free world” order, allows it to outperform its relative economic power. As America’s current Defence Secretary, Chuck Hagel, said earlier this year, “We (the USA) do not engage in the world because we are a great nation. Rather, we are a great nation because we engage in the world.” Nevertheless the US is losing its place as the sole dominant geopolitical superpower and history suggests that during such shifts geopolitical tensions structurally increase. If this analysis is correct then the rise in the past five years, and most notably in the past year, of global geopolitical tensions may well prove not temporary but structural to the current world system and the world may continue to experience more frequent, longer lasting and more far reaching geopolitical stresses than it has in at least two decades. If this is indeed the case then markets might have to price in a higher degree of geopolitical risk in the years ahead.

via Zero Hedge http://ift.tt/1womgFE Tyler Durden

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McStain is in charge of our vetting

And moderate rebels we’re getting

It’s all just a game

These guys are the same

And fighting for ISIL

I’m betting

The Limerick King

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.

;.

PROTECT THE AMERICA!

via Zero Hedge http://ift.tt/1pYHQrF williambanzai7

Authored by PIMCO's Paul McCulley,

When I entered the Fed-watching business over three decades ago, a clichéd phrase of advice from graybeards was: “Watch what they do, not what they say.” Thinking back, there was not actually much Fed rhetoric to either watch or hear.

Paul Volcker was new in the job of Fed Chairman, Ronald Reagan had just been elected President, and Ted Turner had not yet launched CNN Headline News. All three men are now recognized as giants of transformative change in America’s life, altering not just how we conduct our affairs, but also how we think about ourselves.

It really was a good time to be a newly minted graduate in short pants on Wall Street. The fiscal authority was pursuing something called supply side economics and the monetary authority was putatively pursuing monetarism. Keynes was in rehab for inflationary intoxication, and Friedman was the straw stirring the free-to-choose drink. The visible fist of government was cursed and the invisible hand of markets celebrated.

Ah, yes, a most interesting time to start a career on Wall Street: a time of existential ferment in our nation’s economic policy, best characterized by tight monetary policy, loose fiscal policy and blind belief in the ability and willingness of capitalists to regulate and discipline their own affairs. At such a juncture in history, the advice of the graybeards to me to watch what “they” do rather than what they say was sage counsel.

This was particularly the case in watching the Volcker-led Fed, which pegged short-term interest rates, but said it didn’t, maintaining that it simply controlled growth in the money stock via changes in “the degree of pressure on bank reserve positions.” Volcker also thundered that the Fed had virtually no influence over long-term interest rates, which were putatively sky high because of outsized budget deficits and inflationary expectations.

Accordingly, the Fed-watching community of that era was, in practice, a community of plumbers: We spent a huge amount of effort and time anticipating and reverse engineering the day-to-day flows (called “operating factors”) that drove the activities of the New York Fed’s Open Market Desk, which were necessary to maintain the existing “degree of pressure on reserve positions.”

Yes, we were obsessed with what the Fed actually did, which they ordinarily did at 11:40 Eastern time: customer repo versus system repo, term versus overnight, bill passes versus coupon passes and the dreaded matched sale. Were the operations strictly “technical,” orchestrated to sterilize the net of churning operating factors, or was the Desk implementing a FOMC-directed change in the degree of pressure on reserves – to wit, changing the FOMC’s implicit fed funds rate target?

To be sure, we Fed nerds were also expected to forecast such changes, with especial focus on changes in the FOMC’s “inter-meeting bias,” also known as the “tilt,” which granted the Chair authority to implement changes without further FOMC deliberations. But our day job was as plumbers, to literally figure out when policy changes were actually unfolding by chasing the Fed’s open market transactions through the banking system’s pipes.

Dot mavens
Now a graybeard, I preach to youngsters the opposite of the sermon I was given: Watch what they say, not what they do. The Secrets of the Temple that Bill Greider wrote so poignantly about in 1983¹ are no longer secret. The FOMC not only very publicly pegs the fed funds rate (albeit in a 25 basis point range, so as to maintain some degree of no-hands-Mom myth), but also provides “forward guidance” as to its fed funds rate peg: The FOMC forecasts itself!

 
 

Thus, the game of Fed forecasting is no longer an absolute sport, as in my youth, but a relative game: The FOMC’s dots are the benchmark, and forecasting is an over-under game versus those dots. To be sure, today’s game is similar to yesterday’s game, in that betting money on Fed forecasts involves wagering relative to market prices, notably the forward curve for future short rates.

What is new is that the forward curve is now an explicit instrument of monetary policy. More bluntly: The Fed explicitly seeks to influence and manage long-term asset prices, all of which, by the (Gordon) laws of financial arithmetic, embed expectations of future Fed policy.

The Fed doesn’t put it exactly that way, of course, preferring to speak of influencing “financial conditions.” Political correctness and all that. But “financial conditions” don’t have ticker symbols with prices: Long-term financial assets do – bonds, stocks and currencies.

Thus, central bank watching in today’s world is all about reverse engineering where central banks “want” those big-three asset prices, which are now Fed “targets,” in a fashion similar to the money stock “targets” of my youth. That is not to suggest, I hasten to add, that central bankers always get what they want!

There are many slips between cup and lip, between instruments and targets. Reality has a nasty habit of intruding on wants and best intentions. And needs.

Doing what we were trained to do!
We Fed-watching plumbers of long ago now finally get to do what, for me, is most rewarding: reverse engineering the internal consistency, or lack thereof, in the FOMC’s theoretical musings. And, in turn, opining on the logic of the explicit FOMC forecasts of its own future behavior, in the context of those theoretical footings.

Yes, for me, it is the most satisfying time of my Fed-watching career. And not just because I’ve got a cool new job, though I do. What I pinch myself most about is actually one blue dot: the FOMC’s “longer-run” forecast of the steady-state “neutral” fed funds rate, which has a current “central tendency” of 3¾%, recently shaved from 4%; see the Dot-ology Box!

Recall: It was only in 2012 that the Fed began explicitly hanging its collective hat on a numerical longer-run forecast for its short-term peg! But the 4% “neutral” number has long existed in the ether of Fedspeak, notably since 1993, when John Taylor devised and divined his famous Rule, which postulates that a perfectly tamed business cycle should/will beget a 4% fed funds rate: a 2% real rate plus an at-target 2% inflation rate, in the context of at-potential, or full-employment, GDP growth.

Taylor’s Rule was and is a cyclical operating guide for the FOMC to modulate the fed funds rate on both sides of secular “neutral,” founded on the cyclical Phillips Curve trade-off between unemployment and inflation. Rational-expectations perfection would be no modulations at all: Markets would so understand the FOMC’s reaction function, efficiently discounting prescribed modulations in the Fed’s policy rate, as to obviate the FOMC from having to make them!

Indeed, Taylor argues – to this very day! – that if only the Fed had religiously followed his Rule over the last two decades, the U.S. economy at present would be in a much finer place than it is. Not a perfect place, to be sure, not even Taylor would argue, but a much better place.

I have no present desire to pick a fight with Taylor about his counterfactual assertion: Serenity starts with accepting that which cannot be changed, and that includes history. Forward!

But I do applaud John for the ubiquity that his Rule has achieved, because it conveniently frames conventional wisdom, which can also be called active intellectual laziness – which has plagued my profession pervasively ever since the Minsky Moment of 2007–2008.

The Taylor Rule was not designed for dealing with Liquidity Trap pathologies, because it was modeled on a time frame that didn’t include any Liquidity Traps! At least in the United States, and when Taylor published his Rule in 1993, Japan was in the infant years of its then-denied Liquidity Trap.

As a pragmatic matter, the Taylor Rule over the last half decade has been useful primarily in confirming the wisdom of Keynes’ parting observation in the closing chapter of The General Theory:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.”

The tenacity of some FOMC participants in defending the rounds-to-4% longer-run blue dot confirms too, perhaps, the robustness of yet another Keynes dictum:

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Channeling Rudi
Long-time – and patient! – readers probably are now bracing for an ode to Minsky, a most unconventional theorist, an outcast and renegade in academic circles, whose Financial Instability Hypothesis has greatly informed and influenced my own work.

Gotcha: Ain’t going to do it!

Rather, I want to riff on the work of another (sadly passed) man, who was held in highest esteem at the highest rungs of the academy: Rudi Dornbusch. In 1976,² Professor Dornbusch took on conventional wisdom that floating exchange rates – adopted after the breakup of the Bretton Woods fixed rate regime a half decade earlier – were inexplicably volatile, relative to the doctrine of monetarism, as espoused by none other than Milton Friedman.

Conventional monetarist religion had held that a regime of floating exchange rates would unleash market forces to adjust exchange rates in real time, guided by the lodestar of Purchasing Power Parity (PPP), thus truncating buildup of imbalances in trade, which had, in the earlier fixed exchange rate regime, begot violent volatility when governments were “forced” to break the fixes.

Reality did not conform to those monetarist promises, with wild over- and under-shooting of PPPs, and Dornbusch sought to theoretically explain why, developing his exquisitely simple, yet elegant model of rational overshooting. Its theoretical foundation is very simple: Prices on Wall Street move much more quickly than prices on Main Street.

Duh, you say, don’t we all know that? Yes, we do. But that reality is often assumed away in economic theory, most especially in high academic churches steeped in the efficient markets hypothesis, presuming that the invisible hands of markets all wear the same behavioral gloves.

They don’t. What Dornbusch demonstrated was that:

1) If a country has an “overvalued” currency on a PPP basis (its burgers are way overpriced relative to the rest of the world on the Big Mac Index) and is experiencing a growth-debilitating erosion in trade, and

2) If the country responds with a “shock” of monetary easing, slashing interest rates (as it is free to do under a floating exchange rate regime!), then

3) Its currency will rationally plummet not just to “fair,” but to “undervalued” on a PPP basis.

The reason:

1) A country’s Main Street prices (inflation) are very slow to adjust to the “shock” of monetary easing (reducing imports and increasing exports, improving growth), and

2) Until that adjustment has unfolded, global investors will be stuck with the country’s shocked-lower interest rates, and accordingly,

3) Will rationally be willing to hold the country’s bonds only if its currency plummets below PPP, fostering expectations of room for future appreciation.

Simply put: Rudi explained to us that global investors will buy a country’s rich bonds only if the country’s currency falls so far as to make its burgers dirt cheap.

Really, his model is that simple, yet profound (as all great breakouts in economic theory tend to be!). In turn, Rudi’s theoretical nugget provides huge insight into the why and how of escape from a Liquidity Trap: Wall Street prices move much more quickly and further than Main Street prices.

Wall Street’s unjust moment
Traditionally, the political catechism of monetary policy is that the Fed doesn’t really give a damn about Wall Street, that the capital markets are only the conduit between the Fed and Main Street. Main Street outcomes for employment and inflation are what really matter, we are taught, and thus the only “targets” of monetary policy. And so long as a Liquidity Trap can be avoided, this theological tenet has a loud ring of truth.

This was particularly the case before financial deregulation, when monetary policy “worked” primarily through the conventional banking system, with Main Street’s savers on the liability side of banks’ balance sheets, and Main Street’s borrowers on the asset side. Wall Street was a place walled off from the banking system (by Glass-Steagall, among other things), where people of money traded securities amongst themselves, while also channeling capital – notably equity – to the frontiers of economic growth.

In that catechism and that world, the notion of the Fed “targeting” stock and other long-term financial asset prices was blasphemy. And politically, it still is. But that world no longer exists: Wall Street and the deregulated banking system – conventional and shadow – have morphed into one.

In turn, when a Liquidity Trap hits, the Fed is in a pickle. The Fed can take its policy rate to the Zero Lower Bound (ZLB), but it will not generate a revival of either increased demand for or supply of bank credit and, in lagged train, upside action for prices and wages on Main Street. Such is the nature of monetary policy in a Liquidity Trap, which is akin to the position of a cheesecake vendor at a convention of recovering overeaters: The customers ain’t buying, even though they are known to like the product, and the price is zero.

In which case, the Fed isn’t impotent. But with the banking system and its Main Street customers locked in the Nurse Ratched Center for Deleveraging of Balance Sheets, where exuberance, rational and otherwise, is strongly discouraged, the monetary authority, by default, must turn to Wall Street for able-and-willing partiers.

Yes, it is a Hobson’s choice. Theoretically, the choice should never be on the table, if the fiscal authority is willing and able to party hardy, backed by the sovereign’s borrowing prowess. But if the fiscal authority demurs, for whatever reasons of defunct orthodoxy, the monetary authority must – unless it wants to nursemaid an enduring Liquidity Trap – dance with Wall Street.

It is not a tasteful choice for the Fed at all. It reeks with social injustice. But it also happens to be the only viable choice: Use all available powers, with whatever-it-takes abandon, to reflate prices that are amenable to going up: long-term bonds and stocks.

How does it work?
Printing money to reflate Wall Street prices is normally thought to “work” through a trickle-down channel: Make the wealthy wealthier and they will spend more ebulliently, stimulating aggregate demand more generally. There is indeed an element of this dynamic involved. But it is not, in my analysis, the straw that stirs the Liquidity Trap-escape drink.

For, you see, Liquidity Traps are born of preceding (Minsky-type) excesses of debt-to-equity ratios. That is, there is too much private sector debt relative to equity, not too much debt per se. It’s a private sector balance sheet problem that begets an income statement problem, not the other way around.

To be sure, a recession in the wake of a Minsky Moment does create an aggregate demand, and thus aggregate income problem, as recessions poleaxe employment and labor’s bargaining power for wage gains. This dynamic turbo-charges Main Street’s woes in managing any given debt-to-equity ratio.

But the existential macro problem in a Liquidity Trap is a balance sheet problem: too little equity relative to debt. This problem can be mightily relieved by driving up the price of assets that are the collateral for debt, thereby restoring and creating equity.

Yes, “creating” equity: Capital gains – realized or not – are the only newly created asset without an associated, offsetting liability. “Paper wealth!” some of you are no doubt retorting under the breath. And arithmetically, I won’t quarrel with you. I will simply remind that a Minsky Moment itself is a “paper” problem: too much dodgy paper debt relative to the paper value of levered assets.

Accordingly, getting out of a Liquidity Trap with monetary policy playing the lead role necessarily involves a Dornbuschian sequence of rational overshooting: The Fed must drive up Wall Street prices, which move quickly, so as to get to Main Street prices that move up slowly, most importantly, wages.

This sequencing implies that Wall Street’s prices axiomatically will, in the short run, “overshoot” their long-term fair value, as the Fed appropriately and credibly commits to staying at the ZLB, until paper wealth creation endogenously deleverages private sector balance sheets sufficiently to restore animal-spirited risk taking on Main Street.

This sequencing implies that Wall Street prices must become very rich relative to Main Street prices in order to achieve so-called escape velocity from the Liquidity Trap. At the transition point, Wall Street prices will be rationally “overvalued” relative to their long-term “fair value.”

Rational? Ain’t it just a bubble? No, because unless and until Main Street prices go up, Wall Street prices will be rationally priced on the assumption – sometimes called a “Fed Put” – that the central bank will stay pinned against the ZLB.

As and when the Rudi Lag plays itself out, however, Wall Street’s prices must rationally re-price to two-sided Fed policy risks.

*  *  *

Bottom line
This process has been unfolding for well over a year now, ever since Ben Bernanke signaled a plan for ending QE3, a necessary condition for the FOMC to even consider lifting off the ZLB. The early stages of Wall Street’s re-pricing, now known as the “taper tantrum,” were rational, even if violent. Ever since, Wall Street has been in a “price discovery” process for what the post-Liquidity Trap “neutral” Fed policy rate should/will be, once the Fed begins liftoff from the ZLB.

Long-term bond prices have rationally not recovered all the ground lost in the taper tantrum: Removal of the Fed Put axiomatically should lift the term premium for duration risk. But yields have fallen, also rationally, as the market has rejected the FOMC’s rounds-to-4% blue dot: PIMCO’s New Neutral before your eyes!

Stock prices are, of course, higher than before the taper tantrum, and rationally so: If bonds reject the FOMC’s 4% blue dot, then stocks should, via a Gordon Model, rationally follow suit. And they have.

Thus, Wall Street has, so far, gotten lucky twice: the Unjust Moment followed by The New Neutral. Somehow, it just doesn’t seem right. And it isn’t; it just is.

But as Martin Luther King intoned long ago, the arc of the universe does bend toward justice. And as I wrote in July,³ I think it will do so with the Fed letting the recovery/expansion rip for a long time, fostering real wage gains for Main Street.

This implies that the dominant risk for Wall Street is not bursting bubbles, but rather a long slow grind down in profit’s share of GDP/national income. And you can stick that into a Gordon Model, too!

Bonds and stocks may at present be rationally valued, but borrowing from the lyrics of Procol Harum’s Keith Reid: Expected long-term returns are turning a more ghostly whiter shade of pale.

via Zero Hedge http://ift.tt/1D22gdH Tyler Durden