From an email I just sent to several friends:
Ok, folks, it's time for another of my patented long-term predictions.
Let's say that Obama gets even a small part of what he promised in the
SOTU. We're talking about massive distortions in incentives and even in
basic industrial efficiency. This guy wants to roll back the industrial
revolution, which would be the net effect of making energy vastly more
expensive and tripling taxes on driving.
My prediction is that the public sector will soak up a far higher
proportion of national production. I've never joined in the chorus of
"the Democrats want to make the US look like Europe circa 1980." But now
I think that's an entirely reasonable expectation. This year's federal
spending will be 26% of GDP, up sharply from the 20 to 22 percent that
we've had every year for decades. As soon as we get it up to 45 or 50
percent, we're in France territory.
And the reduction of free-market choices and incentives just about
everywhere will create the inefficiency that could get us there.
Americans voted to give the government the power to set our economic
priorities, and there's no unscrambling that egg. What they're getting
as part of the bargain is a way of spending that has structural
disincentives to reduce costs. That's why I'm thinking a 45% federal
share of the economy isn't an unreasonable endpoint.
What will the effect be on the private sector? That's the interesting part.
Recently in Emails and Correspondence Category
Continue reading Paris-On-Potomac.
This is a response I just made to a private email, that I thought was worth posting here. Everyone understands why inflation is bad. But I'm very often asked what's so bad about deflation ("wouldn't I be happy if bread cost five cents a loaf, like in 1933?")
No. No, you wouldn't. Because where inflation destroys savings, deflation destroys society.
I'm going to just whisper this because it's not yet clear how far we're going with it. But the thing about deflationary times is that they produce social change, which is sometimes radical change.
Deflationary worlds always produce fewer goods and services (consumables and tradables) than is possible. (The economists would say that the economy is performing below its capacity.) If deflation gets bad enough, the aggregate production of goods and services can fall below what is needed to sustain ordinary survival and basic health for all members of the population. Over time, populations respond to this by getting smaller. In the near term, they can respond by confiscating stores of wealth that are held in private hands.
The latter can happen in hard ways (the French Revolution), semi-hard ways (the New Deal and trade unionism), or soft ways (whatever is going to happen in America over the next five years). The point is that there is stored wealth in private hands, at all times. The social friction arises because privately-held wealth is withheld in times of deflation. People who control wealth are in a position to weather the storm, but people without wealth aren't. If things get bad enough, people without wealth can be relied on to rebel.
Wealth isn't money, which has no reality to begin with. Wealth is assets that can produce goods, like farms, quarries, factories, and the softer assets (such as business relationships) that are needed to produce services. Over time, deflation causes wealth to become socialized. That's where we're going,but no one yet knows how far.
No. No, you wouldn't. Because where inflation destroys savings, deflation destroys society.
I'm going to just whisper this because it's not yet clear how far we're going with it. But the thing about deflationary times is that they produce social change, which is sometimes radical change.
Deflationary worlds always produce fewer goods and services (consumables and tradables) than is possible. (The economists would say that the economy is performing below its capacity.) If deflation gets bad enough, the aggregate production of goods and services can fall below what is needed to sustain ordinary survival and basic health for all members of the population. Over time, populations respond to this by getting smaller. In the near term, they can respond by confiscating stores of wealth that are held in private hands.
The latter can happen in hard ways (the French Revolution), semi-hard ways (the New Deal and trade unionism), or soft ways (whatever is going to happen in America over the next five years). The point is that there is stored wealth in private hands, at all times. The social friction arises because privately-held wealth is withheld in times of deflation. People who control wealth are in a position to weather the storm, but people without wealth aren't. If things get bad enough, people without wealth can be relied on to rebel.
Wealth isn't money, which has no reality to begin with. Wealth is assets that can produce goods, like farms, quarries, factories, and the softer assets (such as business relationships) that are needed to produce services. Over time, deflation causes wealth to become socialized. That's where we're going,but no one yet knows how far.
http://www.politico.com/news/stories/0109/18068.html
Quotes a New York-based hedge fund manager, Andrew Schiff: "Our standard of living needs to come down to the point where it can be supported by organic output."
Dang, that's pithy and totally true. I've written thousands of words for months now, usually including the word "deflation," groping for exactly that point.
I know that several of my friends disagree quite strongly with this view. What he's really saying is that we've been supplementing our consumption by importing spending power in the form of personal and public indebtedness. We've quite rationally been taking advantage of the fact that other countries demand an exceptionally low rate of interest for lending money to us.
Now, the chain has run out on low-cost private indebtedness. There's nothing left in that tank. But if anything, public indebtedness has become even more attractive as long-term interest rates remain preternaturally low. As a result, we're quite rationally going to suck on that tank until it runs dry too.
The only way to overcome behavior that's short-term rational and long-term destructive, is to be king. If I were king of the US, I'd take Schiff's advice and start looking for ways to make the US economy radically more productive. Eliminating the business income tax and the capital gains tax would be awesome places to start. Outlawing unions and dismantling the regulatory state would be next
Quotes a New York-based hedge fund manager, Andrew Schiff: "Our standard of living needs to come down to the point where it can be supported by organic output."
Dang, that's pithy and totally true. I've written thousands of words for months now, usually including the word "deflation," groping for exactly that point.
I know that several of my friends disagree quite strongly with this view. What he's really saying is that we've been supplementing our consumption by importing spending power in the form of personal and public indebtedness. We've quite rationally been taking advantage of the fact that other countries demand an exceptionally low rate of interest for lending money to us.
Now, the chain has run out on low-cost private indebtedness. There's nothing left in that tank. But if anything, public indebtedness has become even more attractive as long-term interest rates remain preternaturally low. As a result, we're quite rationally going to suck on that tank until it runs dry too.
The only way to overcome behavior that's short-term rational and long-term destructive, is to be king. If I were king of the US, I'd take Schiff's advice and start looking for ways to make the US economy radically more productive. Eliminating the business income tax and the capital gains tax would be awesome places to start. Outlawing unions and dismantling the regulatory state would be next
It would be an absolutely remarkable thing, and would be talked and
written about for decades, if we execute a TARP II, or a Bad Bank, or
any such thing. This is the outline: we would be taking a failed
banking system (which at this point consists of a conflation of the
large banks and what used to be known as investment banks), and
subtracting its mistakes out of it. It would be recapitalized via
public funds, much in the manner of WPA works of shlock art in the
Thirties.
But none of the existing stakeholders (common equity and debt, much of which is held by very influential non-Americans including Saudi princes and the Chinese government) will have to suffer more losses than they have already. The American public will literally forgive their mistakes, and create a basis for some already-wealthy people to start getting much wealthier again.
Something tells me that when Obama comes back after his re-election to tell us all that the hard workers among us will need to dig deep and pay much higher taxes, he's not going to put the touch on Prince Al-aweed.
And the banks are going to see massive restrictions placed on their activities, and THAT will be seen as the payback for the public assistance rather than wiping out the existing equity and debt.
And what would this bizarre facsimile of a banking system be engaged in? Not any kind of economy-building finance. It would be involved primarily in mortgage finance, all of which will be guaranteed by the already-nationalized Fannie Mae and Freddie Mac (which last week signaled that they're insolvent too and will quietly be getting funded by a few dozen billion dollars, which was about the total size of their equity capital last summer).
But this isn't necessarily a negative for the economy. Big businesses for decades now have been getting their finance from the CP market rather than from banks. It's going to be hell for small businesses, who will start operating on real money rather than credit lines. This can most certainly be done (I've done it for years) but it means you have smaller businesses that take less risk, and will be far quicker to lay people off.
Expect to see massive public support for two sectors of consumer finance that have traditionally lacked it: auto loans and credit cards. Already the Fed is talking of buying up securitizations of these kinds of loans. Also expect the already-large support for student loans to be beefed up.
The American public is going into the business of consumer finance with both feet. This isn't necessarily bad or evil, except for one problem: the people we get to run our public banking system will be government employees. Getting a car loan or a credit card will be a lot like dealing with the Post Office, the DMV, or the IRS.
And just wait until green-technology cars come along. The banks will be offering much cheaper loans to buy those cars than the traditional kind.
And what of the sheiks and Chinese bureaucrats who will be enjoying the earnings streams from the public banks? Might not be a bad idea to join them now. Although I'm not giving investment advice here, recall that I've been flirting with the idea of buying up bank debt for a while now.
But none of the existing stakeholders (common equity and debt, much of which is held by very influential non-Americans including Saudi princes and the Chinese government) will have to suffer more losses than they have already. The American public will literally forgive their mistakes, and create a basis for some already-wealthy people to start getting much wealthier again.
Something tells me that when Obama comes back after his re-election to tell us all that the hard workers among us will need to dig deep and pay much higher taxes, he's not going to put the touch on Prince Al-aweed.
And the banks are going to see massive restrictions placed on their activities, and THAT will be seen as the payback for the public assistance rather than wiping out the existing equity and debt.
And what would this bizarre facsimile of a banking system be engaged in? Not any kind of economy-building finance. It would be involved primarily in mortgage finance, all of which will be guaranteed by the already-nationalized Fannie Mae and Freddie Mac (which last week signaled that they're insolvent too and will quietly be getting funded by a few dozen billion dollars, which was about the total size of their equity capital last summer).
But this isn't necessarily a negative for the economy. Big businesses for decades now have been getting their finance from the CP market rather than from banks. It's going to be hell for small businesses, who will start operating on real money rather than credit lines. This can most certainly be done (I've done it for years) but it means you have smaller businesses that take less risk, and will be far quicker to lay people off.
Expect to see massive public support for two sectors of consumer finance that have traditionally lacked it: auto loans and credit cards. Already the Fed is talking of buying up securitizations of these kinds of loans. Also expect the already-large support for student loans to be beefed up.
The American public is going into the business of consumer finance with both feet. This isn't necessarily bad or evil, except for one problem: the people we get to run our public banking system will be government employees. Getting a car loan or a credit card will be a lot like dealing with the Post Office, the DMV, or the IRS.
And just wait until green-technology cars come along. The banks will be offering much cheaper loans to buy those cars than the traditional kind.
And what of the sheiks and Chinese bureaucrats who will be enjoying the earnings streams from the public banks? Might not be a bad idea to join them now. Although I'm not giving investment advice here, recall that I've been flirting with the idea of buying up bank debt for a while now.
The last crash happened because systemic risk was pervasively
underpriced. People failed to discount the possibility that home prices
can move downward as well as upward. Removing this risk from the overall
pool of risk that gets sliced and diced in a billion different ways
means that there was too much risk to match the returns generated by the
system.
Now people are streaming back into debt securities that have some kind of exposure (direct, indirect, through spread, or through swap) to explicit government guarantees or to an expectation of government support. The risk management that should be imposed by people performing good old-fashioned credit-quality analysis, is instead being provided by the promise of government liquidity.
This is a system made of moral hazard. The people who benefit from it, by definition, are the ones who game the system. Traditional retail investing is now a sucker's game, and the intrinsic value of our money is now highly questionable.
It's quite possible to sustain for a very long time a system in which business and financial risk is implicitly underwritten by monetary authorities. Rather than being taken by stockholders of banks and investment firms, losses will ultimately be borne by low-end consumers, who will experience either contraction in the economy, or high inflation, or both.
It won't be sustainable if there is another bubble somewhere. Bubbles happen when the risk of loss becomes decoupled from the risk of gain. Bubbles are automatically prevented in normal times by people who stand to lose money if they make bad decisions. There's no intelligence required. It's a stable feedback loop.
But in the nascent world of socialized risk, you can easily get bubbles, and the only thing that can stop them is for government authorities to see them coming and stop them ahead of time. Much knowledge, intelligence and luck is required. It's NOT a stable system.
Now people are streaming back into debt securities that have some kind of exposure (direct, indirect, through spread, or through swap) to explicit government guarantees or to an expectation of government support. The risk management that should be imposed by people performing good old-fashioned credit-quality analysis, is instead being provided by the promise of government liquidity.
This is a system made of moral hazard. The people who benefit from it, by definition, are the ones who game the system. Traditional retail investing is now a sucker's game, and the intrinsic value of our money is now highly questionable.
It's quite possible to sustain for a very long time a system in which business and financial risk is implicitly underwritten by monetary authorities. Rather than being taken by stockholders of banks and investment firms, losses will ultimately be borne by low-end consumers, who will experience either contraction in the economy, or high inflation, or both.
It won't be sustainable if there is another bubble somewhere. Bubbles happen when the risk of loss becomes decoupled from the risk of gain. Bubbles are automatically prevented in normal times by people who stand to lose money if they make bad decisions. There's no intelligence required. It's a stable feedback loop.
But in the nascent world of socialized risk, you can easily get bubbles, and the only thing that can stop them is for government authorities to see them coming and stop them ahead of time. Much knowledge, intelligence and luck is required. It's NOT a stable system.
I had this thought while I was trying to decide whether a huge
Keynesian stimulus will be likely to trigger an unhealthy amount of
inflation (as pre-monetarist Keynesian theory actually suggests).
The major effect that is transforming finance in a fundamental way is de-leveraging. (The major effect that is transforming finance in a cyclical way, on the other hand, is the destruction of bank equity.) By "de-leveraging," I mean the end of financing models based on huge amounts of short-term borrowing, constantly rolled over, at very low interest rates.
A leveraged financial system behaves just like a leveraged physical one: small changes in inputs produce large changes in outputs. (The difference in finance, of course, is that the changes are usually nonlinear.) Leverage is a beautiful thing when you're making money, because you can make more money than would be suggested by the amount of nominal risk you take.
Leverage is an evil thing when you start losing money, because every adverse movement is magnified, and you quickly get into situations where you no longer have freedom over your actions. (Margin calls force you to sell good assets, which means that everything becomes undervalued at once. Across the whole global economy, this is exactly what produces panics, as in 1998 and 2007.)
So you could well argue that financial de-leveraging is ultimately a good thing. It will certainly (and necessarily) produce economic pain, because it means that nominal returns on capital will be lower. (Footnote: I keep talking about "nominal" returns rather than risk-adjusted ones, as a way of acknowledging that high leverage, as practiced in recent years, actually masked rather than reduced overall investment risk, a fact that didn't become evident until 2007.) But if the system is less susceptible to cascades of forced asset sales, that can only make it more stable, and more resilient. It will behave more like markets theoretically behave, discounting available information correctly, rather than exhibiting obviously erroneous undervaluations.
But I'm thinking that rather than allowing the financial world to de-leverage, the response of policy makers around the world has been to pursue desperate measures to keep markets more or less where they are, or at least not to let them fall farther. Obviously, they're responding to the political distress that happens when millions of people see their life savings suddenly sliced in half.
What if there's a law of conservation of leverage? Rather than being based on inexpensive short-term borrowings, the system is now dependent on blanket risk-guarantees by governments and monetary authorities. And the US economy will very soon be getting a great deal of its demand generated by a quite small number of people in the White House and in Congress.
And the biggest overvalued asset class of all, US housing, is stubbornly refusing to lose value because Congress, the Fed, and the FDIC won't let it.
There still is a tremendous amount of leverage in the financial system. It's just moved from one place to another. The leverage is now contained in the fact that decisions made by a very small number of very powerful people will disproportionately affect the system. Small inputs produce large outputs. The fact that these decisions will be made from political rather than economic motivations is hair-raising.
Highly-leveraged nonlinear systems exhibit wild, unpredictable and rapid swings in behavior. The economic projections that are the basis of the stimulus proposals aren't likely to come anywhere near the truth. This year might be as economically dramatic as last year. Welcome to our strange new world.
The major effect that is transforming finance in a fundamental way is de-leveraging. (The major effect that is transforming finance in a cyclical way, on the other hand, is the destruction of bank equity.) By "de-leveraging," I mean the end of financing models based on huge amounts of short-term borrowing, constantly rolled over, at very low interest rates.
A leveraged financial system behaves just like a leveraged physical one: small changes in inputs produce large changes in outputs. (The difference in finance, of course, is that the changes are usually nonlinear.) Leverage is a beautiful thing when you're making money, because you can make more money than would be suggested by the amount of nominal risk you take.
Leverage is an evil thing when you start losing money, because every adverse movement is magnified, and you quickly get into situations where you no longer have freedom over your actions. (Margin calls force you to sell good assets, which means that everything becomes undervalued at once. Across the whole global economy, this is exactly what produces panics, as in 1998 and 2007.)
So you could well argue that financial de-leveraging is ultimately a good thing. It will certainly (and necessarily) produce economic pain, because it means that nominal returns on capital will be lower. (Footnote: I keep talking about "nominal" returns rather than risk-adjusted ones, as a way of acknowledging that high leverage, as practiced in recent years, actually masked rather than reduced overall investment risk, a fact that didn't become evident until 2007.) But if the system is less susceptible to cascades of forced asset sales, that can only make it more stable, and more resilient. It will behave more like markets theoretically behave, discounting available information correctly, rather than exhibiting obviously erroneous undervaluations.
But I'm thinking that rather than allowing the financial world to de-leverage, the response of policy makers around the world has been to pursue desperate measures to keep markets more or less where they are, or at least not to let them fall farther. Obviously, they're responding to the political distress that happens when millions of people see their life savings suddenly sliced in half.
What if there's a law of conservation of leverage? Rather than being based on inexpensive short-term borrowings, the system is now dependent on blanket risk-guarantees by governments and monetary authorities. And the US economy will very soon be getting a great deal of its demand generated by a quite small number of people in the White House and in Congress.
And the biggest overvalued asset class of all, US housing, is stubbornly refusing to lose value because Congress, the Fed, and the FDIC won't let it.
There still is a tremendous amount of leverage in the financial system. It's just moved from one place to another. The leverage is now contained in the fact that decisions made by a very small number of very powerful people will disproportionately affect the system. Small inputs produce large outputs. The fact that these decisions will be made from political rather than economic motivations is hair-raising.
Highly-leveraged nonlinear systems exhibit wild, unpredictable and rapid swings in behavior. The economic projections that are the basis of the stimulus proposals aren't likely to come anywhere near the truth. This year might be as economically dramatic as last year. Welcome to our strange new world.
USD at $1.38, coming off a huge collapse in the Treasury market the last
two days.
Some people are seeing signs that risk aversion is starting to abate in capital markets around the world. It's a hard case to make, because it depends on success by the US in stimulating our economy. The way this line of reasoning goes, interest rates will stay at near-zero in the developed economies, but the US fiscal stimulus will work. That will revive interest in the emerging economies, resulting in capital flight from the US, a much lower dollar, and a much steeper yield curve.
The contrary case is that extreme risk aversion will continue as financial institutions around the world seek ever-higher capital ratios in a world that feels like no one is really in charge. That scenario calls for a continued flat yield curve with unprecedented low rates for Treasury debt, a possibly strong dollar rally, and a threat of deflation.
So by the end of 2009, will the dollar be closer to $1.20 or to $1.60?
Tossup.
Some people are seeing signs that risk aversion is starting to abate in capital markets around the world. It's a hard case to make, because it depends on success by the US in stimulating our economy. The way this line of reasoning goes, interest rates will stay at near-zero in the developed economies, but the US fiscal stimulus will work. That will revive interest in the emerging economies, resulting in capital flight from the US, a much lower dollar, and a much steeper yield curve.
The contrary case is that extreme risk aversion will continue as financial institutions around the world seek ever-higher capital ratios in a world that feels like no one is really in charge. That scenario calls for a continued flat yield curve with unprecedented low rates for Treasury debt, a possibly strong dollar rally, and a threat of deflation.
So by the end of 2009, will the dollar be closer to $1.20 or to $1.60?
Tossup.
