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There was a time when the merest mention of gold manipulation in “reputable” media was enough to have one branded a perpetual conspiracy theorist with a tinfoil farm out back. That was roughly coincident with a time when Libor, FX, mortgage, and bond market manipulation was also considered unthinkable, when High Frequency Traders were believed to “provide liquidity”, or when the stock market was said to not be manipulated by the Fed, and when the ever-confused media, always eager to take “complicated” financial concepts at the face value set by a self-serving establishment, never dared to question anything. Luckily, all that changed in the past several years, and it has gotten to the point where even the bastions of “serious”, if 3-5 years delayed, investigation are finally not only asking how is the gold market being manipulated, but are actually providing answers.

Such as Bloomberg.

The topic of gold market manipulation during the London AM fix is not new to Zero Hedge: in fact we have discussed both the historical basis and the raison d’etre of the London gold fix, as well as the curious arbitrage available to those who merely traded the AM-PM spread, for years. Which is why we are delighted that none other than Bloomberg has decided to break it down for everyone, as well as summarize all the ways in which just this one facet of gold trading is being manipulated.

Bloomberg begins:

Every business day in London, five banks meet to set the price of gold in a ritual that dates back to 1919. Now, dealers and economists say knowledge gleaned on those calls could give some traders an unfair advantage when buying and selling the precious metal. The London fix, the benchmark rate used by mining companies, jewelers and central banks to buy, sell and value the metal, is published twice daily after a telephone call involving Barclays Plc, Deutsche Bank AG, Bank of Nova Scotia, HSBC Holdings Plc and Societe Generale SA.

 

The fix dates back to September 1919, less than a year after the end of World War I, when representatives from five dealers met at Rothschild’s office on St. Swithin’s Lane in London’s financial district. It was suspended for 15 years, starting in 1939. While Rothschild pulled out in 2004 and the discussions now take place by telephone instead of in a wood-paneled room at the bank, the process remains much the same.

That much is known. What is certainly known is that any process that involves five banks sitting down (until recently literally) and exchanging information using arcane methods (such as a telephone), on a set schedule that involves a private information blackout phase, even if temporary, and that does not involve instant market feedback, can and will be gamed. “Traders involved in this price-determining process have knowledge which, even for a short time, is superior to other people’s knowledge,” said Thorsten Polleit, chief economist at Frankfurt-based precious-metals broker Degussa Goldhandel GmbH and a former economist at Barclays. “That is the great flaw of the London gold-fixing.”

There are other flaws.

Participants on the London call can tell whether the price of gold is rising or falling within a minute or so, based on whether there are a large number of net buyers or sellers after the first round, according to gold traders, academics and investors interviewed by Bloomberg News. It’s this feature that could allow dealers and others in receipt of the information to bet on the direction of the market with a high degree of certainty minutes before the fix is made public, they said.

Yes, the broader momentum creation and ignition perspective is also known to most. At least most who never believed the boilerplate that unlike all other asset classes, gold is somehow immune from manipulation.

“Information trickles down from the five banks, through to their clients and finally to the broader market,” Andrew Caminschi, a lecturer at the University of Western Australia in Perth and co-author of a Sept. 2 paper on trading spikes around the London gold fix published online in the Journal of Futures Markets, said by phone. “In a world where trading advantage is measured in milliseconds, that has some value.”

Ah, theoretical – smart. One mustn’t ruffle feathers before, like in the case of Libor, it becomes fact that everyone was in on it.

There’s no evidence that gold dealers sought to manipulate the London fix or worked together to rig prices, as traders did with Libor. Even so, economists and academics say the way the benchmark is set is outdated, vulnerable to abuse and lacking any direct regulatory oversight. “This is one of the most concerning fixings I have seen,” said Rosa Abrantes-Metz, a professor at New York University’s Stern School of Business whose 2008 paper, “Libor Manipulation?” helped spark a global probe. “It’s controlled by a handful of firms with a direct financial interest in where it’s set, and there is virtually no oversight — and it’s based on information exchanged among them during undisclosed calls.”

Unless we are wrong, there was no evidence of Libor manipulative collusion before there was evidence either. And since the cabal of the London gold fix is far smaller than the member banks of Libor, it is exponentially easier to confine intent within an even smaller group of people. But all that is also known to most.

As is the fact that when asked for comments, ‘spokesmen for Barclays, Deutsche Bank, HSBC and Societe Generale declined to comment about the London fix or the regulatory probes, as did Chris Hamilton, a spokesman for the FCA, and Steve Adamske at the CFTC. Joe Konecny, a spokesman for Bank of Nova Scotia, wrote in an e-mail that the Toronto-based company has “a deeply rooted compliance culture and a drive to continually look toward ways to improve our existing processes and practices.”

Next, Bloomberg conveniently goes into the specifics of just how the gold price is manipulated first by the fixing banks, then by their “friends and neighbors” as news of the fixing process unfolds.

At the start of the call, the designated chairman — the job rotates annually among the five banks — gives a figure close to the current spot price in dollars for an ounce of gold. The firms then declare how many bars of the metal they wish to buy or sell at that price, based on orders from clients as well as their own account.

 

If there are more buyers than sellers, the starting price is raised and the process begins again. The talks continue until the buy and sell amounts are within 50 bars, or about 620 kilograms, of each other. The procedure is carried out twice a day, at 10:30 a.m. and 3 p.m. in London. Prices are set in dollars, pounds and euros. Similar gauges exist for silver, platinum and palladium.

 

The traders relay shifts in supply and demand to clients during the calls and take fresh ord
ers to buy or sell as the price changes, according to the website of London Gold Market Fixing, which publishes the results of the fix.

.. only this time the manipulation is no longer confined to a purely theoretical plane and instead empirical evidence of the fixing leak is presented based on academic research:

Caminschi and Richard Heaney, a professor of accounting and finance at the University of Western Australia, analyzed two of the most widely traded gold derivatives: gold futures on Comex and State Street Corp.’s SPDR Gold Trust, the largest bullion-backed exchange-traded product, from 2007 through 2012.

 

At 3:01 p.m., after the start of the call, trading surged to 47.8 percent above the average for the 20-minute period preceding the start of the fix and remained 20 percent higher for the next six minutes, Caminschi and Heaney found. By comparison, trading was 8.7 percent higher than the average a minute after publication of the price. The results showed a similar pattern for the SPDR Gold Trust.

 

“Intuitively, we expect volumes to spike following the introduction of information to the market” when the final result is published, Caminschi and Heaney wrote in “Fixing a Leaky Fixing: Short-Term Market Reactions to the London P.M. Gold Price Fixing.” “What we observe in our analysis is a clustering of trades immediately following the fixing start.”

 

The researchers also assessed how accurate movements in gold derivatives were in predicting the final fix. Between 2:59 p.m. and 3 p.m., the direction of futures contracts matched the direction of the fix about half the time.

 

From 3:01 p.m., the success rate jumped to 69.9 percent, and within five minutes it had climbed to 80 percent, Caminschi and Heaney wrote. On days when the gold price per ounce moved by more than $3, gold futures successfully predicted the outcome in more than nine out of 10 occasions. “Not only are the trades quite accurate in predicting the fixing direction, the more money that is made by way of a larger price change, the more accurate the trade becomes,” Caminschi and Heaney wrote. “This is highly suggestive of information leaking from the fixing to these public markets.”

Oh please, 9 out of 10 times is hardly indicative of any wrongdoing. After all, JPM lost money on, well, zero trading days in all of 2013, and nobody cares. So if a coin landing heads about 200 times in a row is considered normal by regulators, then surely the CTFC will find nothing wrong with a little gold manipulation here and there. Manipulation, which it itself previously said did not exist. But everyone already knew that too.

Cynicism aside, to claim that this clearly gamed process is not in fact gamed, not to say criminally manipulated (because it is never manipulation unless one is caught in the act by enforcers who are actually not in on the scheme) is the height of idiocy. Which is why we are certain that regulators will go precisely this route. That too is also largely known. Also known are the benefits for traders who abuse the London fix:

For derivatives traders, the benefits are clear: A dealer who bought 500 gold futures contracts at 3 p.m. and knew the fix was going higher could make $200,000 for his firm if the price moved by $4, the average move in the sample. While the value of 500 contracts totals about $60 million, traders may buy on margin, a process that involves borrowing and requires placing less capital for the bet. On a typical day, about 4,500 futures contracts are traded between 3 p.m. and 3:15 p.m., according to Caminschi and Heaney.

Finally what is certainly known is that the “London fixing” fix would be very simple in our day and age of ultramodern technology, and require a few minutes of actual implementation.

Abrantes-Metz, who helped Iosco formulate its guidelines, said the gold fix’s shortcomings may stretch beyond giving firms and clients access to privileged information. “There is a huge incentive for these banks to try and influence where the benchmark is set depending on their trading positions, and there is almost no scrutiny,” she said.

 

Abrantes-Metz said the gold fix should be replaced with a benchmark calculated by taking a snapshot of trading in a market where $19.6 trillion of the precious metal circulated last year, according to CPM Group, a New York-based research company. “There’s no reason why data cannot be collected from actual prices of spot gold based on floor or electronic trading,” she said. “There’s more than enough data.”

Which is precisely why nothing will change. Sadly, that is also widely known.

So did Bloomberg put together an exhaustive article in which virtually everything was known a priori? it turns out the answer is no: we learned one thing.

London Gold Market Fixing Ltd., a company controlled by the five banks that administers the benchmark, has no permanent employees. A call from Bloomberg News was referred to Douglas Beadle, 68, a former Rothschild banker, who acts as a consultant to the company from his home in Caterham, a small commuter town 45 minutes south of London by train. Beadle declined to comment on the benchmark-setting process.

You learn something new every day.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/gaHmS6aVHXg/story01.htm Tyler Durden

Submitted by Pater Tenebrarum of Acting-Man blog,

Krugman, Summers and the First Keynesian

Paul Krugman has used the occasion of Larry Summers' speech at the IMF to lay out his economic views, or let us rather say, his economic fallacies. As we already mentioned, the fact that Krugman liked Summers' speech proves ipso facto that it was a bunch of arrant nonsense. Krugman has subsequently proved us right beyond a shadow of doubt. A great many long refuted Keynesian shibboleths keep being resurrected in Krugman's fantasy-land, where economic laws are magically suspended, virtue becomes vice and bubbles and the expropriation of savers the best ways to grow the economy. It is important to keep in mind in this context that most of what Keynes wrote in the General Theory wasn't original – it was mainly a rehashing of the underconsumption and inflationist fallacies propagated by his less famous predecessors. As Henry Hazlitt remarked in his detailed refutation of Keynes (“The Failure of the New Economics”):

“I have analyzed Keynes's General Theory in the following pages theorem by theorem, chapter by chapter, and sometimes even sentence by sentence, to what to some readers may appear a tedious length, and I have been unable to find in it a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, as we shall find, even much that is fallacious in the book is not original, but can be found in a score of previous writers.”

If one looks back at the history of economic thought, the earliest proponent of what we know as Keynesian errors today was probably John Law, the infamous Scotsman who almost single-handedly managed to ruin the economy of France (in fact, all of Europe was thrown into a depression lasting decades as a result of Law's monetary experiment). He was convinced that what the economy lacked was 'spending' and so endeavored to provide it with the necessary means – in spades. The result was a giant asset bubble and crack-up boom that left the economy in utter ruins when it ended.

Although Law's scheme involved speculation in the shares of what turned out to be a company that was worth much less than advertised, at the heart of the operation was a monetary scheme based on his previously developed theories. The plan involved the printing of oodles of unbacked paper money which Law thought would spur a revival of France's moribund economy and concurrently fix the government's tattered finances. As is almost always the case with inflationary schemes, it appeared to work initially. In fact, it seemed to work almost too well (if Tonto had been around, he would have noticed that something was wrong). The world's first 'millionaires' were created, for a brief time at least (most of them ended up as paupers, similar to Law himself).

The problem with all such schemes is essentially that scarce resources end up being invested unwisely, as inflation makes it appear as though they were more plentiful than they really are. Once the inevitable collapse comes, these unwise investments are unmasked and it become obvious to all that capital has been squandered.

 

---

 

John Law – the world's first Keynesian

(Image via Wikimedia Commons)

 

---

 

One of the ultimately worthless paper promises issued by Law's Banque Générale

(Image via Wikimedia Commons)

 

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The 'Logic' of Nonsense

What we noted above regarding 'wise' and 'unwise' investment is an important point to keep in mind when considering Krugman's rehashing of Keynesian fallacies. Krugman writes:

“Larry’s formulation of our current economic situation is the same as my own. Although he doesn’t use the words “liquidity trap”, he works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – is negative.

 

And as he also notes, in this situation the normal rules of economic policy don’t apply. As I like to put it, virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment, thanks to the paradox of thrift. Fixating on debt and deficits deepens the depression. And so on down the line.”

(emphasis added)

We already discussed that the idea that the natural interest rate can become negative is a fallacy (see “Meet Larry Summers, Social Engineer” for more color on this). To briefly summarize, for the natural rate to go negative, time preferences would have to go negative too, as interest rates are merely the ratio between present and future goods. However, a situation in which human beings value attaining the same satisfaction in a more remote future more highly than attaining it in a nearer future is simply unthinkable (capitalistic saving, i.e., abstaining from present consumption, always aims at obtaining more goods and/or services in the future).

All this 'liquidity trap' and 'paradox of thrift' stuff makes no sense whatsoever. Savings are not 'lost' to the economy, they are the sine qua non without which capital accumulation and production are not possible. Virtue doesn't become vice in an economic downturn and economic laws don't change. As William Anderson points out in a recent article, the problem with this thinking is that it ignores capital theory. Attempts to revive the economy with deficit spending and inflation will never stimulate all factors of production simultaneously and to the same extent. The moment one considers the heterogeneity of capital it becomes clear that such interventions must lead to distortions which result in the boom-bust cycle (the housing bubble that expired in 2007/8 provides us with an excellent recent example for this).

Krugman elaborates further, once again invoking space aliens in the process:

“This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coalmines and letting the private sector dig it up – or my version, which involves faking a threat from nonexistent space aliens – becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing.”

It is simply incorrect that 'unproductive spending is better than nothing'. Recall what we said above about 'wise and unwise investment'. Deploying scarce resources in unproductive fashion is not 'better than nothing', it will simply consume capital and destroy wealth. Krugman continues along these lines, seemingly eager to enlist everyone in his plan to waste as much capital as possible:

“Larry also indirectly states an important corollary: this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future. That last bit is an important qualification. But suppose that U.S. corporations, which are currently sitting on a huge hoard of cash, were somehow to become convinced that it would be a great idea to fit out all their employees as cyborgs, with Google Glass and smart wristwatches everywhere. And suppose that three years later they realized that there wasn’t really much payoff to all that spending. Nonetheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would otherwise have been idle.

 

OK, this is still mostly standard, although a lot of people hate, just hate, this kind of logic – they want economics to be a morality play, and they don’t care how many people have to suffer in the process.”

(emphasis added)

So 'wasteful spending is a good thing unless it stores up trouble for the future' – Krugman says that this is an 'important qualification', only to proceed to show us in the next breath that he actually does not feel constrained by any such 'qualification' at all. Presumably he put that filler sentence in there so that when people in the future take a look at what he recommended in the past, he can claim to have 'qualified' his demand for wasteful spending (recall his vocal demand for a housing bubble before housing bubbles turned out to be uncool, which continues to cause him well-deserved embarrassment). When the latest scheme to 'rescue' the economy by inflation and deficit spending fails, he will be able to dig up this 'important qualification' (as if there could be any wasteful spending that doesn't store up trouble for the future).

The idea that 'idle resources' need to be pressed into service is also due to Krugman having no inkling of capital theory. In the Keynesian view of the world, capital is a self-replicating homogeneous blob, some portions of which are currently accidentally 'idled' and only need to be prodded back into action with the help of  government spending. This is not so. Capital is not only heterogeneous, much of it is highly specific and inconvertible. What appears to be unnecessarily 'idle' are simply the remnants of previous malinvestments. It may no longer make economic sense to employ the capital concerned. Workers who used to be employed in lines of production the products of which are no longer in demand may be holding out, hoping for the sector to 'come back' rather than accepting a lower wage in a different occupation.

As an example, consider the housing sector that was at the center of the previous boom. If building companies have invested in enough machinery to erect two million houses per year, but I has turned out that there is only demand for 400,000 houses, it wouldn't make sense to employ the superfluous machinery and construct two million houses per year anyway. People that were employed in construction may need to retrain or move and be willing to accept less remunerative work. It is certain that e.g. far fewer roofers are needed today than during the building boom. Renewed credit expansion is likely to affect different sectors of the economy, but if it leads to another artificial boom in the same sector, it will merely prolong the life of malinvested capital and delay the necessary adjustments. Krugman argues along Keynesian lines that  'stuff the government has dropped into coal mines should be dug up', but neglects that this activity doesn't come without costs (or rather, erroneously argues that the costs don't matter).

Krugman avers that this 'logic' is hated because people are informed by a warped sense of morality. The problem has nothing to do with morals though, the problem is that there is simply no 'logic' discernible. Krugman offers the most illogical ideas and then proceeds to call them 'logic' as if that could somehow dignify them and mitigate the fact that they are offending common sense.

 

More Bubbles Please

Believe it or not, it gets still more absurd. Not only does Krugman conclude that it is supposedly advisable to engage in unproductive spending because it is 'better than nothing', he also believes that Summers' speech contains an unspoken demand for more bubbles. And why not? After all, he has already concluded that 'prudence is folly', so why not throw prudence overboard, lock, stock and barrel? Never mind that this is what policy makers are already doing, so there hardly seems a great need to egg them on. According to Krugman:

“We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.

 

So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles? But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?

 

So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’ answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest.”

(emphasis added)

The seemingly insoluble questions Krugman grapples with are not as difficult as he makes them out to be. The problem is that what he calls 'inflation' is only one of its many possible effects. Where the effects of inflation on prices first appear is a matter of the specific historical circumstances. Given strongly rising economic productivity, a huge expansion in international trade (and let us not forget, the transformation of the former communist command economies into market economies), it should be no great surprise that the effects of the huge credit expansion and money supply inflation of recent decades showed up in asset prices rather than consumer prices (incidentally, a very similar thing happened during the boom of he 1920s, during which economists also ignored a major credit and money supply expansion because consumer prices were tame due to strong increases in productivity).

This does not mean that other negative effects of these inflationary credit bubbles didn't put in an appearance. They all caused a distortion of relative prices and were thus all marked by massive capital malinvestment. Successive credit expansions led temporarily to higher employment even as capital was misallocted, but a steadily worsening underlying structural situation has become evident as these booms have inevitably turned into busts. So what solution does Krugman have to offer? He evidently thinks coercion and theft are the best way forward:

“Of course, the underlying problem in all of this is simply that real interest rates are too high. But, you say, they’re negative – zero nominal rates minus at least some expected inflation. To which the answer is, so? If the market wants a strongly negative real interest rate, we’ll have persistent problems until we find a way to deliver such a rate.

 

One way to get there would be to reconstruct our whole monetary system – say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom – whether it’s a bubble or driven by expansionary fiscal policy – to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations.”

(emphasis added)

Or putting it differently: do what John Law did and destroy what's left of the economy. The elimination of paper money (i.e., cash), would force people  (whether they like it or not) to keep their money in what are essentially insolvent fractionally reserved banks that have proved beyond a shadow of doubt that they cannot be trusted. This poses no problem for Krugman, because it would make it easier to steal people's savings via the imposition of 'negative interest rates' (i.e., a regular penalty to be deducted from their hard earned money).

Krugman then expresses his advance surprise at why anyone would be outraged by this combination of abject economic nonsense and outright theft. After all, it would amount to nothing but the good old 'euthanasia of the rentier' once recommended by Keynes:

Any such suggestions are, of course, met with outrage. How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It’s tyranny!

 

But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.

(emphasis added)

What Krugman proposes here is indeed tyranny. The 'liquidity trap' is a figment of the Keynesian imagination anyway – no such thing exists. A positive rate of return on savings doesn't need to be 'promised' by anyone, it would be the natural state of affairs in a free market economy. Krugman then jumps to yet another conclusion, namely that in light of the above, the size and growth rate of the public debt would of course no longer matter at all:

“Oh, and one last point. If we’re going to have persistently negative real interest rates along with at least somewhat positive overall economic growth, the panic over public debt looks even more foolish than people like me have been saying: servicing the debt in the sense of stabilizing the ratio of debt to GDP has no cost, in fact negative cost.

 

I could go on, but by now I hope you’ve gotten the point.”

(emphasis added)

Well, we can at least be grateful that he didn't 'go on'.

 

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Too much debt? No problem, just impose negative interest rates! – click to enlarge.

 

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Summary and Conclusion:

According to Paul Krugman, saving is evil and savers should therefore be forcibly deprived of positive interest returns. This echoes the 'euthanasia of the rentier' demanded by Keynes, who is the most prominent source of the erroneous underconsumption theory Krugman is propagating. Similar to John Law and scores of inflationists since then, he believes that economic growth is driven by 'spending' and consumption. This is putting the cart before the horse. We don't deny that inflation and deficit spending can create a temporary illusory sense of prosperity by diverting scarce resources from wealth-generating toward wealth-consuming activities. It should however be obvious that this can only lead to severe long term economic problems.

In fact, the last credit boom, in which policy makers fully implemented what Krugman and other Keynesians proposed, has done enormous structural damage. Not even the biggest spending spree and money supply expansion of the entire post WW2 era has been able to divert enough wealth into bubble activities to create a full-blown pseudo-'recovery' so far. Krugman's conclusion seems to be that more of the same is needed. In other words, we are supposed to repeat what clearly hasn't worked before, only on a much greater scale.

Finally it should be pointed out that the idea that economic laws are somehow 'different' in periods of economic contraction is a cop-out mainly designed to prevent people from asking an obvious question: if deficit spending and inflation are so great, why not always pursue them?

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/3bA03w8EPiE/story01.htm Tyler Durden

Submitted by Pater Tenebrarum of Acting-Man blog,

Krugman, Summers and the First Keynesian

Paul Krugman has used the occasion of Larry Summers' speech at the IMF to lay out his economic views, or let us rather say, his economic fallacies. As we already mentioned, the fact that Krugman liked Summers' speech proves ipso facto that it was a bunch of arrant nonsense. Krugman has subsequently proved us right beyond a shadow of doubt. A great many long refuted Keynesian shibboleths keep being resurrected in Krugman's fantasy-land, where economic laws are magically suspended, virtue becomes vice and bubbles and the expropriation of savers the best ways to grow the economy. It is important to keep in mind in this context that most of what Keynes wrote in the General Theory wasn't original – it was mainly a rehashing of the underconsumption and inflationist fallacies propagated by his less famous predecessors. As Henry Hazlitt remarked in his detailed refutation of Keynes (“The Failure of the New Economics”):

“I have analyzed Keynes's General Theory in the following pages theorem by theorem, chapter by chapter, and sometimes even sentence by sentence, to what to some readers may appear a tedious length, and I have been unable to find in it a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, as we shall find, even much that is fallacious in the book is not original, but can be found in a score of previous writers.”

If one looks back at the history of economic thought, the earliest proponent of what we know as Keynesian errors today was probably John Law, the infamous Scotsman who almost single-handedly managed to ruin the economy of France (in fact, all of Europe was thrown into a depression lasting decades as a result of Law's monetary experiment). He was convinced that what the economy lacked was 'spending' and so endeavored to provide it with the necessary means – in spades. The result was a giant asset bubble and crack-up boom that left the economy in utter ruins when it ended.

Although Law's scheme involved speculation in the shares of what turned out to be a company that was worth much less than advertised, at the heart of the operation was a monetary scheme based on his previously developed theories. The plan involved the printing of oodles of unbacked paper money which Law thought would spur a revival of France's moribund economy and concurrently fix the government's tattered finances. As is almost always the case with inflationary schemes, it appeared to work initially. In fact, it seemed to work almost too well (if Tonto had been around, he would have noticed that something was wrong). The world's first 'millionaires' were created, for a brief time at least (most of them ended up as paupers, similar to Law himself).

The problem with all such schemes is essentially that scarce resources end up being invested unwisely, as inflation makes it appear as though they were more plentiful than they really are. Once the inevitable collapse comes, these unwise investments are unmasked and it become obvious to all that capital has been squandered.

 

---

 

John Law – the world's first Keynesian

(Image via Wikimedia Commons)

 

---

 

One of the ultimately worthless paper promises issued by Law's Banque Générale

(Image via Wikimedia Commons)

 

---

 

The 'Logic' of Nonsense

What we noted above regarding 'wise' and 'unwise' investment is an important point to keep in mind when considering Krugman's rehashing of Keynesian fallacies. Krugman writes:

“Larry’s formulation of our current economic situation is the same as my own. Although he doesn’t use the words “liquidity trap”, he works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the “natural” rate of interest – the rate at which desired savings and desired investment would be equal at full employment – is negative.

 

And as he also notes, in this situation the normal rules of economic policy don’t apply. As I like to put it, virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment, thanks to the paradox of thrift. Fixating on debt and deficits deepens the depression. And so on down the line.”

(emphasis added)

We already discussed that the idea that the natural interest rate can beco
me negative is a fallacy (see “Meet Larry Summers, Social Engineer” for more color on this). To briefly summarize, for the natural rate to go negative, time preferences would have to go negative too, as interest rates are merely the ratio between present and future goods. However, a situation in which human beings value attaining the same satisfaction in a more remote future more highly than attaining it in a nearer future is simply unthinkable (capitalistic saving, i.e., abstaining from present consumption, always aims at obtaining more goods and/or services in the future).

All this 'liquidity trap' and 'paradox of thrift' stuff makes no sense whatsoever. Savings are not 'lost' to the economy, they are the sine qua non without which capital accumulation and production are not possible. Virtue doesn't become vice in an economic downturn and economic laws don't change. As William Anderson points out in a recent article, the problem with this thinking is that it ignores capital theory. Attempts to revive the economy with deficit spending and inflation will never stimulate all factors of production simultaneously and to the same extent. The moment one considers the heterogeneity of capital it becomes clear that such interventions must lead to distortions which result in the boom-bust cycle (the housing bubble that expired in 2007/8 provides us with an excellent recent example for this).

Krugman elaborates further, once again invoking space aliens in the process:

“This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coalmines and letting the private sector dig it up – or my version, which involves faking a threat from nonexistent space aliens – becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing.”

It is simply incorrect that 'unproductive spending is better than nothing'. Recall what we said above about 'wise and unwise investment'. Deploying scarce resources in unproductive fashion is not 'better than nothing', it will simply consume capital and destroy wealth. Krugman continues along these lines, seemingly eager to enlist everyone in his plan to waste as much capital as possible:

“Larry also indirectly states an important corollary: this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future. That last bit is an important qualification. But suppose that U.S. corporations, which are currently sitting on a huge hoard of cash, were somehow to become convinced that it would be a great idea to fit out all their employees as cyborgs, with Google Glass and smart wristwatches everywhere. And suppose that three years later they realized that there wasn’t really much payoff to all that spending. Nonetheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would otherwise have been idle.

 

OK, this is still mostly standard, although a lot of people hate, just hate, this kind of logic – they want economics to be a morality play, and they don’t care how many people have to suffer in the process.”

(emphasis added)

So 'wasteful spending is a good thing unless it stores up trouble for the future' – Krugman says that this is an 'important qualification', only to proceed to show us in the next breath that he actually does not feel constrained by any such 'qualification' at all. Presumably he put that filler sentence in there so that when people in the future take a look at what he recommended in the past, he can claim to have 'qualified' his demand for wasteful spending (recall his vocal demand for a housing bubble before housing bubbles turned out to be uncool, which continues to cause him well-deserved embarrassment). When the latest scheme to 'rescue' the economy by inflation and deficit spending fails, he will be able to dig up this 'important qualification' (as if there could be any wasteful spending that doesn't store up trouble for the future).

The idea that 'idle resources' need to be pressed into service is also due to Krugman having no inkling of capital theory. In the Keynesian view of the world, capital is a self-replicating homogeneous blob, some portions of which are currently accidentally 'idled' and only need to be prodded back into action with the help of  government spending. This is not so. Capital is not only heterogeneous, much of it is highly specific and inconvertible. What appears to be unnecessarily 'idle' are simply the remnants of previous malinvestments. It may no longer make economic sense to employ the capital concerned. Workers who used to be employed in lines of production the products of which are no longer in demand may be holding out, hoping for the sector to 'come back' rather than accepting a lower wage in a different occupation.

As an example, consider the housing sector that was at the center of the previous boom. If building companies have invested in enough machinery to erect two million houses per year, but I has turned out that there is only demand for 400,000 houses, it wouldn't make sense to employ the superfluous machinery and construct two million houses per year anyway. People that were employed in construction may need to retrain or move and be willing to accept less remunerative work. It is certain that e.g. far fewer roofers are needed today than during the building boom. Renewed credit expansion is likely to affect different sectors of the economy, but if it leads to another artificial boom in the same sector, it will merely prolong the life of malinvested capital and delay the necessary adjustments. Krugman argues along Keynesian lines that  'stuff the government has dro
pped into coal mines should be dug up', but neglects that this activity doesn't come without costs (or rather, erroneously argues that the costs don't matter).

Krugman avers that this 'logic' is hated because people are informed by a warped sense of morality. The problem has nothing to do with morals though, the problem is that there is simply no 'logic' discernible. Krugman offers the most illogical ideas and then proceeds to call them 'logic' as if that could somehow dignify them and mitigate the fact that they are offending common sense.

 

More Bubbles Please

Believe it or not, it gets still more absurd. Not only does Krugman conclude that it is supposedly advisable to engage in unproductive spending because it is 'better than nothing', he also believes that Summers' speech contains an unspoken demand for more bubbles. And why not? After all, he has already concluded that 'prudence is folly', so why not throw prudence overboard, lock, stock and barrel? Never mind that this is what policy makers are already doing, so there hardly seems a great need to egg them on. According to Krugman:

“We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.

 

So you might be tempted to say that monetary policy has consistently been too loose. After all, haven’t low interest rates been encouraging repeated bubbles? But as Larry emphasizes, there’s a big problem with the claim that monetary policy has been too loose: where’s the inflation? Where has the overheated economy been visible?

 

So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers’ answer is that we may be an economy that needs bubbles just to achieve something near full employment – that in the absence of bubbles the economy has a negative natural rate of interest.”

(emphasis added)

The seemingly insoluble questions Krugman grapples with are not as difficult as he makes them out to be. The problem is that what he calls 'inflation' is only one of its many possible effects. Where the effects of inflation on prices first appear is a matter of the specific historical circumstances. Given strongly rising economic productivity, a huge expansion in international trade (and let us not forget, the transformation of the former communist command economies into market economies), it should be no great surprise that the effects of the huge credit expansion and money supply inflation of recent decades showed up in asset prices rather than consumer prices (incidentally, a very similar thing happened during the boom of he 1920s, during which economists also ignored a major credit and money supply expansion because consumer prices were tame due to strong increases in productivity).

This does not mean that other negative effects of these inflationary credit bubbles didn't put in an appearance. They all caused a distortion of relative prices and were thus all marked by massive capital malinvestment. Successive credit expansions led temporarily to higher employment even as capital was misallocted, but a steadily worsening underlying structural situation has become evident as these booms have inevitably turned into busts. So what solution does Krugman have to offer? He evidently thinks coercion and theft are the best way forward:

“Of course, the underlying problem in all of this is simply that real interest rates are too high. But, you say, they’re negative – zero nominal rates minus at least some expected inflation. To which the answer is, so? If the market wants a strongly negative real interest rate, we’ll have persistent problems until we find a way to deliver such a rate.

 

One way to get there would be to reconstruct our whole monetary system – say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom – whether it’s a bubble or driven by expansionary fiscal policy – to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations.”

(emphasis added)

Or putting it differently: do what John Law did and destroy what's left of the economy. The elimination of paper money (i.e., cash), would force people  (whether they like it or not) to keep their money in what are essentially insolvent fractionally reserved banks that have proved beyond a shadow of doubt that they cannot be trusted. This poses no problem for Krugman, because it would make it easier to steal people's savings via the imposition of 'negative interest rates' (i.e., a regular penalty to be deducted from their hard earned money).

Krugman then expresses his advance surprise at why anyone would be outraged by this combination of abject economic nonsense and outright theft. After all, it would amount to nothing but the good old 'euthanasia of the rentier' once recommended by Keynes:

Any such suggestions are, of cou
rse, met with outrage. How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It’s tyranny!

 

But in a liquidity trap saving may be a personal virtue, but it’s a social vice. And in an economy facing secular stagnation, this isn’t just a temporary state of affairs, it’s the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn’t want to deliver – it’s like farm price supports, except for rentiers.

(emphasis added)

What Krugman proposes here is indeed tyranny. The 'liquidity trap' is a figment of the Keynesian imagination anyway – no such thing exists. A positive rate of return on savings doesn't need to be 'promised' by anyone, it would be the natural state of affairs in a free market economy. Krugman then jumps to yet another conclusion, namely that in light of the above, the size and growth rate of the public debt would of course no longer matter at all:

“Oh, and one last point. If we’re going to have persistently negative real interest rates along with at least somewhat positive overall economic growth, the panic over public debt looks even more foolish than people like me have been saying: servicing the debt in the sense of stabilizing the ratio of debt to GDP has no cost, in fact negative cost.

 

I could go on, but by now I hope you’ve gotten the point.”

(emphasis added)

Well, we can at least be grateful that he didn't 'go on'.

 

---

 

Too much debt? No problem, just impose negative interest rates! – click to enlarge.

 

---

 

Summary and Conclusion:

According to Paul Krugman, saving is evil and savers should therefore be forcibly deprived of positive interest returns. This echoes the 'euthanasia of the rentier' demanded by Keynes, who is the most prominent source of the erroneous underconsumption theory Krugman is propagating. Similar to John Law and scores of inflationists since then, he believes that economic growth is driven by 'spending' and consumption. This is putting the cart before the horse. We don't deny that inflation and deficit spending can create a temporary illusory sense of prosperity by diverting scarce resources from wealth-generating toward wealth-consuming activities. It should however be obvious that this can only lead to severe long term economic problems.

In fact, the last credit boom, in which policy makers fully implemented what Krugman and other Keynesians proposed, has done enormous structural damage. Not even the biggest spending spree and money supply expansion of the entire post WW2 era has been able to divert enough wealth into bubble activities to create a full-blown pseudo-'recovery' so far. Krugman's conclusion seems to be that more of the same is needed. In other words, we are supposed to repeat what clearly hasn't worked before, only on a much greater scale.

Finally it should be pointed out that the idea that economic laws are somehow 'different' in periods of economic contraction is a cop-out mainly designed to prevent people from asking an obvious question: if deficit spending and inflation are so great, why not always pursue them?

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/3bA03w8EPiE/story01.htm Tyler Durden

Even the most ardent of bulls would ‘admit’ that the period of the last 90s was a bubble in US equities. What started at the margin quickly morphed into a euphoric valuation for any and everything that could be pitched. Even The Fed’s Jim Bullard ‘knew’ there was a bubble back then… Today’s recovery of the NASDAQ to 4,000 – levels not seen since this period – is quickly dismissed by those that need things to go higher on the basis of earnings, multiples, or some such forward-looking hope-based methodology that reinforces their bias. However, Tobin’s Q – among the longest-lived and most well-respected of longer-term valuation methodologies has just reached levels only ever seen during the 1999/2000 bubble. BTFATH valuation?

 

Doug Short provides more color here…

The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Financial Accounts of the United States of the United States, which is released quarterly.

 

 

Source: Doug Short’s Advisor Perspectives

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/OaS7cPIxzT0/story01.htm Tyler Durden

Even the most ardent of bulls would ‘admit’ that the period of the last 90s was a bubble in US equities. What started at the margin quickly morphed into a euphoric valuation for any and everything that could be pitched. Even The Fed’s Jim Bullard ‘knew’ there was a bubble back then… Today’s recovery of the NASDAQ to 4,000 – levels not seen since this period – is quickly dismissed by those that need things to go higher on the basis of earnings, multiples, or some such forward-looking hope-based methodology that reinforces their bias. However, Tobin’s Q – among the longest-lived and most well-respected of longer-term valuation methodologies has just reached levels only ever seen during the 1999/2000 bubble. BTFATH valuation?

 

Doug Short provides more color here…

The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Financial Accounts of the United States of the United States, which is released quarterly.

 

 

Source: Doug Short’s Advisor Perspectives

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/OaS7cPIxzT0/story01.htm Tyler Durden

Submitted by Peter Schiff via Euro Pacific Capital,

Herd mentality can be as frustrating as it is inexplicable. Once a crowd starts moving, momentum can be all that matters and clear signs and warnings are often totally ignored. Financial markets are currently following this pattern with respect to the unshakable belief that the Federal Reserve is ready, willing, and most importantly, able, to immediately execute a wind down of its quantitative easing program. How this notion became so deeply entrenched is a mystery, but the stampede it has sparked is getting more violent, and irrational, by the day.

The release last week of the minutes of the October Fed policy meeting was a case study in dangerous collective delusion. Although the report did not contain a shred of hard information about the certainty or timing of a “tapering” campaign, most observers read into it definitive proof that the Fed would jump into action by December or March at the latest.

But while the Fed was gaining much attention by saying nothing, the Chinese made a blockbuster statement that was summarily ignored. Last week, a deputy governor of the People’s Bank of China said that buying foreign exchange reserves was now no longer in China’s national interest. The implication that China may no longer be accumulating U.S. government debt would amount to the “mother of all tapers” and could create a clear and present danger to the American economy. But the story barely rated a mention in the American media.

Instead, the current environment is all about the imminent Fed taper: the process of winding down the Fed’s monthly purchases of $85 billion of treasury debt and mortgage-backed securities. However, the crowd fails to grasp that the Fed has embarked on an impossible mission. The herd is blissfully unaware that the Fed may not be able to reverse, or even slow, the course of QE without immediately sending the economy back into recession.

In an interview this week, outgoing Fed Chairman Ben Bernanke likened the QE program to the first stage in a multiple stage rocket that gets the spacecraft off the ground and accelerates it to the point where it is close to achieving permanent orbit. Like a first stage that has spent its fuel and has become dead weight, Bernanke seems to concede that QE is no longer capable of providing positive thrust, and as a result can now be jettisoned (like a first stage) so that the remainder of the spacecraft/economy can now move higher and faster. The Chairman’s nifty metaphor provides some inspiring visuals, but is completely flawed in just about every way imaginable.

In real rocketry, when the first stage separates, it falls back to earth and is no longer a burden to the remainder of the ship. Subsequent booster rockets (which in economic terms Bernanke imagines would be continuation of zero interest rate policies) build on the gains made by the first stage. But the almost $4 trillion in assets that the Fed has accumulated as a result of the QE program will not simply vaporize into the stratosphere like a discarded rocket engine. In fact it will remain tethered to the rest of the economy with chains of solid lead.

In the process of accumulating the world’s largest cache of Treasuries, the Fed has become the most important player in that market. I believe the Fed can’t stop accumulating and dispose of its inventory without creating major market disruptions that will drag the economy down.

This would be true even if the economic rocket were actually approaching escape velocity. In reality, we are still sitting on the launch pad. By keeping interest rates far below market levels and by channeling newly created dollars directly into the financial markets, the QE program has resulted in major gains in the stock, real estate, and bond markets. Many have argued that all three are currently in bubble territory. Yet to the casual observer, these gains are proof of America’s surging economic vitality.

But things look very different on Main Street, where the employment picture has not kept pace with the rising prices of financial assets. The work force participation rate continues to shrink (recently falling back to levels last seen in 1978),real wages have declined, and since the end of 2009 the temporary workforce has grown at a pace that is 14 times faster than those with permanent jobs. Americans are driving less, vacationing less, and switching to lower quality products and services in order to deal with falling purchasing power.

But the herd is closely watching the Fed’s rocket show and does not understand that stocks and housing will likely fall, and bond yields rise steeply, once the QE is removed. The crowd is similarly ignoring the significance of the Chinese announcement.

Over the past decade or so, the People’s Bank of China has been one of the largest buyers of U.S. Treasuries (after various U.S. government entities that are essentially nationalizing U.S. debt). China currently sits on $1 trillion or more in U.S. bond obligations.

So, just as many expect that the #1 buyer of Treasuries (the Fed) will soon begin paring back its purchases, the top foreign holder may cease buying, thereby opening a second front in the taper campaign. This should cause any level-headed observer to conclude that the market for such bonds will fall dramatically, causing severe upward pressure on interest rates. But the possibility is not widely discussed.

Also left out of the discussion is the degree to which remaining private demand for Treasuries is a function of the Fed’s backstop (the Greenspan put, renewed by Bernanke, and expected to be maintained by Yellen). The ultra-low yields currently offered by long-term Treasuries are only acceptable to investors so long as the Fed removes the risk of significant price declines. If the private buyers, the Fed, China (and other central banks that may likely follow China’s lead) refuse to buy Treasuries, who will take on the slack?  Absent the Fed’s backstop, prices will likely have to fall considerably to offer an acceptable risk/reward dynamic to investors. The problem is that any yield high enough to satisfy investors may be too high for the government or the economy to afford.

Little thought seems to be given to how the economy would react to 5% yields on 10 year Treasuries (a modest number in historical standards). The herd assumes that our stronger economy could handle such levels. In reality, 5% rates would likely deeply impact the financial sector, prick the bubbles in housing and stocks, blow a hole in the federal budget, and cause sizable losses in the value of the Fed’s bond holdings. These developments would require the Fed to devise a rocket with even more power than the one it is now thinking of discarding.

That is why when it comes to tapering, the Fed is all bark and no bite. In fact, toward the end of last week, Dennis Lockhart, President of the Federal Reserve Bank of Atlanta, said that the Fed “won’t taper its bond-buying until the economy is ready.”He must know that the economy will never be ready. It’s like a drug addict claiming that he’ll stop using when he no longer needs them to stay high.

But the market understands none of this. Instead it is operating under dangerous delusions that are creating sky-high valuations for the latest social media craze, undermining the investment case for gold and other inflation hedges, and encouraging people to ignore growing risks that are hiding in plain sight.

This is not unusual in market history. When the spell is finally broken and markets wake up to reality, we will scratch our heads and wonder how we could ever have been so misguided.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/wp1CZULar2E/story01.htm Tyler Durden

Submitted by Peter Schiff via Euro Pacific Capital,

Herd mentality can be as frustrating as it is inexplicable. Once a crowd starts moving, momentum can be all that matters and clear signs and warnings are often totally ignored. Financial markets are currently following this pattern with respect to the unshakable belief that the Federal Reserve is ready, willing, and most importantly, able, to immediately execute a wind down of its quantitative easing program. How this notion became so deeply entrenched is a mystery, but the stampede it has sparked is getting more violent, and irrational, by the day.

The release last week of the minutes of the October Fed policy meeting was a case study in dangerous collective delusion. Although the report did not contain a shred of hard information about the certainty or timing of a “tapering” campaign, most observers read into it definitive proof that the Fed would jump into action by December or March at the latest.

But while the Fed was gaining much attention by saying nothing, the Chinese made a blockbuster statement that was summarily ignored. Last week, a deputy governor of the People’s Bank of China said that buying foreign exchange reserves was now no longer in China’s national interest. The implication that China may no longer be accumulating U.S. government debt would amount to the “mother of all tapers” and could create a clear and present danger to the American economy. But the story barely rated a mention in the American media.

Instead, the current environment is all about the imminent Fed taper: the process of winding down the Fed’s monthly purchases of $85 billion of treasury debt and mortgage-backed securities. However, the crowd fails to grasp that the Fed has embarked on an impossible mission. The herd is blissfully unaware that the Fed may not be able to reverse, or even slow, the course of QE without immediately sending the economy back into recession.

In an interview this week, outgoing Fed Chairman Ben Bernanke likened the QE program to the first stage in a multiple stage rocket that gets the spacecraft off the ground and accelerates it to the point where it is close to achieving permanent orbit. Like a first stage that has spent its fuel and has become dead weight, Bernanke seems to concede that QE is no longer capable of providing positive thrust, and as a result can now be jettisoned (like a first stage) so that the remainder of the spacecraft/economy can now move higher and faster. The Chairman’s nifty metaphor provides some inspiring visuals, but is completely flawed in just about every way imaginable.

In real rocketry, when the first stage separates, it falls back to earth and is no longer a burden to the remainder of the ship. Subsequent booster rockets (which in economic terms Bernanke imagines would be continuation of zero interest rate policies) build on the gains made by the first stage. But the almost $4 trillion in assets that the Fed has accumulated as a result of the QE program will not simply vaporize into the stratosphere like a discarded rocket engine. In fact it will remain tethered to the rest of the economy with chains of solid lead.

In the process of accumulating the world’s largest cache of Treasuries, the Fed has become the most important player in that market. I believe the Fed can’t stop accumulating and dispose of its inventory without creating major market disruptions that will drag the economy down.

This would be true even if the economic rocket were actually approaching escape velocity. In reality, we are still sitting on the launch pad. By keeping interest rates far below market levels and by channeling newly created dollars directly into the financial markets, the QE program has resulted in major gains in the stock, real estate, and bond markets. Many have argued that all three are currently in bubble territory. Yet to the casual observer, these gains are proof of America’s surging economic vitality.

But things look very different on Main Street, where the employment picture has not kept pace with the rising prices of financial assets. The work force participation rate continues to shrink (recently falling back to levels last seen in 1978),real wages have declined, and since the end of 2009 the temporary workforce has grown at a pace that is 14 times faster than those with permanent jobs. Americans are driving less, vacationing less, and switching to lower quality products and services in order to deal with falling purchasing power.

But the herd is closely watching the Fed’s rocket show and does not understand that stocks and housing will likely fall, and bond yields rise steeply, once the QE is removed. The crowd is similarly ignoring the significance of the Chinese announcement.

Over the past decade or so, the People’s Bank of China has been one of the largest buyers of U.S. Treasuries (after various U.S. government entities that are essentially nationalizing U.S. debt). China currently sits on $1 trillion or more in U.S. bond obligations.

So, just as many expect that the #1 buyer of Treasuries (the Fed) will soon begin paring back its purchases, the top foreign holder may cease buying, thereby opening a second front in the taper campaign. This should cause any level-headed observer to conclude that the market for such bonds will fall dramatically, causing severe upward pressure on interest rates. But the possibility is not widely discussed.

Also left out of the discussion is the degree to which remaining private demand for Treasuries is a function of the Fed’s backstop (the Greenspan put, renewed by Bernanke, and expected to be maintained by Yellen). The ultra-low yields currently offered by long-term Treasuries are only acceptable to investors so long as the Fed removes the risk of significant price declines. If the private buyers, the Fed, China (and other central banks that may likely follow China’s lead) refuse to buy Treasuries, who will take on the slack?  Absent the Fed’s backstop, prices will likely have to fall considerably to offer an acceptable risk/reward dynamic to investors. The problem is that any yield high enough to satisfy investors may be too high for the government or the economy to afford.

Little thought seems to be given to how the economy would react to 5% yields on 10 year Treasuries (a modest number in historical standards). The herd assumes that our stronger economy could handle such levels. In reality, 5% rates would likely deeply impact the financial sector, prick the bubbles in housing and stocks, blow a hole in the federal budget, and cause sizable losses in the value of the Fed’s bond holdings. These developments would require the Fed to devise a rocket with even more power than the one it is now thinking of discarding.

That is why when it comes to tapering, the Fed is all bark and no bite. In fact, toward the end of last week, Dennis Lockhart, President of the Federal Reserve Bank of Atlanta, said that the Fed “won’t taper its bond-buying until the economy is ready.”He must know that the economy will never be ready. It’s like a drug addict claiming that he’ll stop using when he no longer needs them to stay high.

But the market understands none of this. Instead it is operating under dangerous delusions that are creating sky-high valuations for the latest social media craze, undermining the investment case for gold and other inflation hedges, and encouraging people to ignore growing risks that are hiding in plain sight.

This is not unusual in market history. When the spell is finally broken and markets wake up to reality, we will scratch our heads and wonder how we could ever
have been so misguided.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/wp1CZULar2E/story01.htm Tyler Durden

Submitted by Ben Hunt of Epsilon Theory

The 18th Brumaire of Janet Yellen

One of the more painful lessons in investing is that the prudent investor (or ‘value investor’ if you prefer) almost invariably must forego plenty of fun at the top end of markets. This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that’s life. And with a Fed like ours it’s probably what we deserve.

      – Jeremy Grantham, macro fund manager and noted Bear (Nov. 19, 2013)

 

I cannot look at myself in the mirror; everything I have believed in I have had to reject. This environment only makes sense through the prism of trends.

      – Hugh Hendry, macro fund manager and noted Bear (Nov. 22, 2013)

 

The hippies, who had never really believed they were the wave of the future anyway, saw the election results as brutal confirmation of the futility of fighting the establishment on its own terms.

      – Hunter S. Thompson, “The Hashbury is the Capital of the Hippies” (1967)

 

In the sunset of dissolution, everything is illuminated by the aura of nostalgia, even the guillotine.

      – Milan Kundera, “The Unbearable Lightness of Being” (1984)

 

The Greek word for ‘return’ is nostos. Algos means ‘suffering.’ So nostalgia is the suffering caused by an unappeased yearning to return.

      – Milan Kundera, “Ignorance” (2000)

 

The class which has the means of material production at its disposal, has control at the same time over the means of mental production. The ruling ideas are nothing more than the ideal expression of the dominant material relationships.

      – Karl Marx, “The German Ideology” (1846)

 

“Let’s go.” “We can’t.” “Why not?” “We’re waiting for Godot.”

      – Samuel Beckett, “Waiting for Godot” (1953)

Karl Marx may not have had a small-l liberal bone in his body, but he was one of the keenest observers of the human condition to ever live, and his writings are a phenomenal resource for anyone seeking to understand our lives as social animals. In 1852 Marx published an essay titled The 18th Brumaire of Louis Bonaparte, recounting the 1851 coup where Louis-Napoleon Bonaparte (nephew of THE Napoleon) seized dictatorial powers in France. The essay was, Marx wrote, intended to “demonstrate how the class struggle in France created circumstances and relationships that made it possible for a grotesque mediocrity to play a hero’s part,” and it is here that Marx describes his view of the individual’s role in history. Which is to say … not much, as individuals are almost always prisoners of the past and their class, particularly shadow or derivative individuals, as Louis-Napoleon was to his uncle and Yellen is to Bernanke. This was the essay where Marx famously said that history always repeats itself, only the second time as farce, a phenomenon I’ve written about at length as the emergency Fed policies that saved the world in 2009 have been transformed into a more or less permanent government insurance program.

I started this note with quotes from two prominently bearish money managers – Jeremy Grantham and Hugh Hendry – both of whom are throwing in the towel on the upward trajectory of the market in the face of inexorable government bond-buying. Their change of heart reflects (finally and begrudgingly) the overwhelmingly dominant Narrative of Central Bank Omnipotence, that for better or worse it is central bank policy (particularly the Fed’s QE policy) that determines market outcomes. This Narrative is encapsulated in the following chart, a graph that we’ve all seen a million times in one form or another and has become a meme unto itself.

This is the Common Knowledge of our day … that so long as the Fed continues to buy, the market will continue to go up. Maybe they taper the rate of purchases or even stop expanding altogether, but if the market gets squirrelly they will just start buying again. The Narrative of Central Bank Omnipotence doesn’t mean that the market will only go up; it means that central bank policy is the overwhelming causal factor for market levels. It is as powerful a Common Knowledge structure as I’ve ever measured, and it’s at the heart of Grantham and Hendry’s hand-wringing. They aren’t capitulating to the market going up, but to WHY the market is going up. It’s a market dynamic that is alien to their (formidable) talents as money managers and to their (strongly held) belief structures on the meaning of an investment.

But for both Grantham and Hendry (and I suspect every investor who has been fighting the Fed in one way or another), this is a temporary capitulation. They both cling to the notion that this, too, shall pass, that we shall someday return to a market environment where real-world business fundamentals matter more than monetary policy. Maybe the return to “normal” comes with a bang … some sort of “Minsky moment” and asset price collapse where there’s a sudden realization that the Emperor has no clothes (or no more bonds to buy) … or maybe it comes with a whimper, as the Fed slowly and calmly drains the excess reserves it has built up in the financial system with the magical “tools” that are touted every time Bernanke (and now Yellen) testifies before Congress. To which I say … maybe. Or maybe that’s just wishful thinking for a market clearing Shock Ending or Happy Ending, as opposed to what seems to me to be the more likely outcome of the Entropic Ending, a long gray slog through a more or less permanently depressed world and a more or less permanently Fed-centric market.

Louis-Napoleon’s reign may have been a farcical shadow of his uncle’s Emperorship, but the truth is that Napoleon I set into motion structural changes in the world that dominate o
ur lives still. Napoleon changed the meaning of nationalism. He changed the meaning of war. He changed what it means to live as a human animal in a mass society. I mean, the entire concept of mass society really begins with Napoleon and the levée en masse, the Napoleonic Code, the notion of Total War, and the authoritarian co-opting of revolutionary ideals. Put the political inventions of Napoleon (and his Prussian and English opponents) together with the mechanical inventions of the Industrial Revolution and you have … the modern nation-state, a massive and entrenched insurance company attached to an equally massive and entrenched standing army.

I think it’s likely that government policy initiatives of the past ten years, particularly monetary policy and particularly US monetary policy, have created a structural shift in the meaning of capital markets and the global economy that rivals what Napoleon did almost exactly 200 years ago. I think Larry Summers is right – we are mired in a world of secular stagnation and a more or less permanent liquidity trap. The degree to which ZIRP and QE and bubble-promoting monetary policy creates that secular stagnation by delaying the deleveraging, loss assignment, and creative destruction that vibrant growth requires is ludicrously underappreciated in Summers’ speech, but as a statement of economic reality it’s pretty spot-on. I think Paul Krugman is right, too – in for a penny, in for a pound. Central bankers have come this far. Do you really think they’re going to back down now? I’m not saying that Krugman’s argument is “right” in terms of being intellectually honest or even very smart. I’m saying that I believe it is an accurate representation of the world as it is.

Here’s the crucial part of what Summers and Krugman are saying: this is not a temporary gig. This isn’t going to just “get better” on its own over time. This really is, as Mohamed El-Erian of PIMCO would call it, the New Normal. And if you’re Jeremy Grantham or anyone for whom a stock has meaning as a fractional ownership stake in a real-world company rather than as a casino chip that gives you “market exposure” … well, that’s really bad news.

So what’s the point of all this?

Denial ain’t just a river in Egypt, and alienation ain’t just a movie with Mandy Patinkin in heavy make-up. For my money, the smartest thing Marx ever wrote was on the concept of alienation, the separation of a worker from the meaning of his labor. Marx believed that the greatest theft that capitalism perpetrated on the working class was psychological. The Industrial Revolution and the assembly line crushed a worker’s spirit by eliminating the sense of pride, the sense of accomplishment, the sense of place and meaning that an honest day’s work previously imbued. Instead of seeing, feeling, and knowing the object of his labor, the modern worker made … a widget. He made a cog and he was a cog.

What traditional value investors like Grantham are experiencing today is alienation in the traditional Marxist sense. In today’s context it’s not the separation of a worker from the meaning of his labor, but the separation of an investor from the meaning of his investment. Sure, you can go on investing on the basis of your discounted cash-flow model or your earnings margin reversion-to-the-mean model or whatever it is that floats your boat, but it’s just going to be a continuing exercise in frustration so long as we live in a Fed-centric universe. As Hugh Hendry says, it’s hard to look at yourself in the mirror every morning when everything that you’ve held dear as your investment belief structure doesn’t seem to matter much anymore. Nostalgia, as Milan Kundera points out, is a form of suffering. Life’s way too short to wallow in those waters.

Marx has an answer to the alienation problem … end it, don’t amend it. Take your ball and go home, or at least find a different game. For the alienated proletariat, this is easier said than done. You’ve got to throw off your chains, rise up in violent class struggle, create a vanguard political party that maintains the necessary ideological discipline, watch out for counter-revolutionaries … creating a worker’s paradise is hard work! For the alienated value investor, on the other hand, the portability of capital makes the road to greener pastures quite a bit easier — just get out of public markets. Go buy a farm … or an apartment building … or a fleet of tankers … or a portfolio of bank loans … anything where your investment process has meaning again and isn’t hijacked by the game-playing and trend-following that dominates public capital markets. If you have to stay in public securities, at least move into areas of the market where you are not dominated by the game-players and where there remains a critical mass of your fellow value investors to make a community of sorts … small and mid-cap industrials, say, or maybe activist targets. Just don’t kid yourself into thinking that your deep dive into the value fundamentals of some large-cap bank has any predictive value whatsoever for the bank’s stock price, or that a return to the happy days of yesteryear is just around the corner. It doesn’t and it’s not, and even if you’re making money you’re going to be miserable and ornery while you wait nostalgically for what you do and what you’re good at to matter again. Spoiler Alert: Godot never shows up.

But maybe you’re not a dyed-in-the-wool value investor wracked by feelings of severe alienation. Maybe you’re pretty agnostic about the whole investment style box thing and you’re just looking to grow your wealth as quickly as possible with the least risk as possible. If you don’t really care WHY the markets are going up, only that they ARE going up; if you don’t feel an existential angst about Fed policy, but are actually quite happy that they’ve got your back; if you’re looking to play the investment game better, regardless of what the rule changes might be … well, Marx has some good advice for you, too. Think for yourself.

Marx is most famous for his concept of “the means of production”, the notion that human history is best seen and understood through an economic lens, that what we have been told is a story of Great Men and Empires and Discovery is really just a byproduct of class struggle for the control of those economic means of production. But what’s less appreciated is that Marx made a distinction between material production (all the stuff that we characterize as economic activity) and what he described as “mental production” – the creation of “the ruling ideas” that do all the heavy lifting in maintaining control over the proletariat. Now Marx wrote this in the 1840’s (!), so it’s going to need some contextual updating to speak clearly to us 170 years later. To wit: in the same way that Marx’s concept of alienation is more relevant today to capitalist investors than it is to labor, so, too, is this concept of mental production and ruling ideas. We investors – big or small, retail or institutional – are the proles. A well-to-do and content proletariat, to be sure, kind of like professional athletes, but a proletariat nonetheless. We control neither the means of material production (the public capital markets in which we labor) nor, more importantly, the means of mental production – the creation of the ruling ideas that drive our behavior and are taken for granted. We are ALL suckers for a good story that has more truthiness (to use Stephen Colbert’s word) than truthfulness, and you don’t have to be a raving Marxist to believe that the institutio
ns that do in fact control the means of material and mental production depend on this central truth about human nature to maintain their position.

What are the ruling ideas in investment theory and practice today? There are plenty, but I’ll highlight two: “stocks for the long haul” and Modern Portfolio Theory. I’m not going to go into a long critique of either ruling idea, as I’ve written on this topic here, and I have lots more planned for the future. But for now I’ll just ask this: does the Narrative of Stocks For the Long Haul or the Narrative of Modern Portfolio Theory serve your best interests and your clients’ best interests … or theirs? It’s a question that deserves to be asked and explored again and again, and that’s what I’ll keep doing with Epsilon Theory.

via Zero Hedge http://feedproxy.google.com/~r/zerohedge/feed/~3/WFFtEElf37M/story01.htm Tyler Durden