Book Review: The Holy Grail of Macroeconomics: Lesson's from Japan's Great Recession

I decided to start adding some book reviews to the blog as a way to keep track of what I've been reading, disclose where some of my ideas and views come from and share both good and bad experiences. I am far from an authority on anything, but I hope someone finds these useful.

Richard C. Koo, Chief Economist of Nomura Reasearch Institute is probably best known for his balance-sheet recession idea that following large credit-fueled asset-price bubble collapses, a private sector finds itself indebted and holding assets that are "underwater," or worth less than the debt used to finance them. Technically, any party in this situation would be insolvent, but if the company still creates healthy profits and can meet it's obligations, it can continue as a going concern. Koo's balance sheet recession lies in the idea that in the environment previously described, the private sector will cease to focus on profit-maximization and instead focus on debt minimization, paying down debt as fast as cash-flows allow so as to get back to solvency.

About the book
In The Holy Grail of Macroeconomics: Lesson's from Japan's Great Recession, Koo uses the idea of a balance-sheet recession to explain both Japan's "lost decade" and the Great Depression. Koo argues that as businesses found themselves highly indebted with assets that had lost value, their focus shifted from profit-maximization to debt-minimization, rendering monetary policy impotent, as no matter how low the interest rate, there simply was no demand for loans. This differs from other accounts, such as Shiller's, which states that, "In the Depression, confidence was so shattered that banks were holding vast unlent sums, and businesses did not want to invest in new capital even though interest rates were at abnormally low levels," in that the lack of demand for funds was a result of over-indebtedness. Koo goes on to very, very thoroughly explain exactly why he thinks so, citing a wealth of evidence. In Koo's view, when the private sector refuses to borrow, deflation can be stopped by the government stepping in and using fiscal policy, borrowing excess funds at a low rate and investing them in the economy to prevent further contractions. In his view, the government becomes the borrower of last-resort intervening to prevent deflation by mopping up all excess reserves and spending them, purportedly in projects with positive net present values,  until private loan-demand returns. Despite my disagreements with certain sections, Koo makes a terrifically good and convincing argument, relentlessly driving his point and shooting down objections before they arise. He shoots down deficit hawks by explaining how businesses returning to profitability with clean and lean balance sheets will produce above-average tax-receipts therefore helping the government clean it's own balance sheet. Additionally, Koo explains how premature retirement of fiscal stimulus would guide a country back to the deflationary path.

The Bad
The first two chapters are hard to read, they drag out and bang the concept of a balance-sheet recession into your head much like a high-school geometry class bangs the "y = mx + b" formula into students' heads. At one point, I felt like I needed to wave a white flag and say "Ok Mr. Koo, you win. Balance sheet recession it is!" Despite this, it is incredibly important to really understand the basic concept before going on to the fun stuff. Chapter 3, is titled "The Great depression was a Balance Sheet Recession" and that's exactly what you'll learn from it. It felt a little like reading a mathematical proof, but was nonetheless interesting. Chapters 4-7 is where the book really shines, though.

The Good
The final four chapters lack the academic dryness of the first three and Koo reads in a much lighter manner, with an incredibly high density of ideas and thoughts per chapter--there is definitely almost no fluff here. Koo outlines his thoughts on possible solutions; the problems of globalization; why normal tools don't work during balance-sheet recessions; monetary, fiscal and foreign exchange policy; and--my personal favorite--ongoing bubbles and balance-sheet recessions. From the problems of free capital flows and carry traders to the US housing bubble, the Chinese bubble and the problems with the German trade surplus, Koo enthusiastically navigates a diverse set of problems with incredible insight and, in hindsight, amazing accuracy for something written before many of these events transpired (2008). He takes no prisoners, doling out jabs to Krugman, Bernanke and Greenspan with no mercy, calling them out when they deserve to be and explaining why he's doing it. I really wish the last section had been eight instead of four chapters, but I guess then he'd be cannibalizing his own business at Nomura.

Conclusion
If you are interested in macroeconomics, read this book. Personal investors and traders are unlikely to find this a useful book if they want information they can use to do that whole turning money into more money thing. Regardless of that, this book really opened my eyes to certain scenarios I hadn't really thought about before. By and large, it wasn't an easy read, but it was a fascinating one. I stayed up night after night thinking about deflationary scenarios and playing "ying or yang economy?" (see image below) in my mind. I would rate this book eight out of ten stars. It was informative, interesting and no-bullshit. It did feel a little dry and academic at times and it really hammered the point at others, but I am confident I will be thinking about--and talking about--this book for quite some time. My biggest criticism is the assumption that the fiscal stimulus will be spent in value-creating projects / activities--I simply don't think politicians can be trusted to do this. Then again the book just explains how one could eliminate a self-feeding deflationary cycle caused by a balance-sheet recession, it never argues right or wrong, it just explains how to stop that, if that's what you want. And that is the question I was left with after reading this book, "is a little deflation really that bad?" I'm of the kind that thinks there is easy things in life and there is hard things, and sometimes you just have to do the hard things.

Selected quotations

German companies responded to the recession by taking advantage of the eurozone's large market and common currency to boost exports to regions with strong economies ... In less flattering terms it has pursued a policy of exporting unemployment to surrounding nations

if individual regions within a currency zone are allowed to run a higher deficit at will, the credibility of the common currency will suffer

asset-price bubbles are typically accompanied by a rapid increase of trading volume ... this gives market participants a false sense of security that those assets are very liquid, and that they can always get out if things start to go wrong.

I was shocked when I saw this, and even considered the Fed chairman had grown senile.

Journalists, meanwhile, are a very different breed. Many want to push for structural reform to change the old economic structure. By setting out an ideal vision for the Japanese economy, they can bask in a sense of superiority and omniscience. This tendency to play God and dictate the "right set" of structural reforms for governments to implement seems particularly strong among journalists based in the U.S. and U.K. But fund managers investing their own money have no time for such self-aggrandizement; they must constantly make prudent by-or-sell decisions based on market realities. Consequently, they are not interested in investing in a country shaken to its foundations by unrealistic structural reforms.

China, bubbles, trade wars and balance of payments

Let's start with the alleged "property bubble," I still have doubts about that big crash coming, increases in property prices have been high, but accounts of high inflation would mean that catastrophic nominal price declines are doubtful. Property prices may lower or stagnate in real terms, but a high rate of inflation--which has its own, different problems--would keep nominal paper profits intact, reducing the risk of widespread loan defaults and huge banking losses that would lead to US-style crash and subsequent balance-sheet recession. Double digit inflation has its problems, but Latin American and other emerging economies have been doing it for many, many years, and they're OK--it's not catastrophic.

Putting aside events that have not happened yet, it's important to look at a bigger picture. As Pettis so eloquently put it last week:

5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences.  Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly.  The most obvious are current account deficit countries like the US.

What we are seeing here is a tough problem for China. On one side it needs to tighten to get a hold on on inflation and prevent potential asset-price bubbles but, on the other hand, doing so would transfer more of the global adjustment burden to itself, losing exports and hurting local businesses. If China decides to keep interest rates low to defend its exporters, potentially negative real interest rates would inevitably create mal-investment and fuel potential bubbles. If it doesn't, then it would risk a recession and widespread pain to its exporters as the result of drastic drops in imports by trade deficit countries as they try to curtail said deficits or even become net exporters. The money-supply data posted earlier is indicative that Chinese "tightening" still leaves pretty loose monetary policy. It really looks like China is in a real bind as a result of its unsustainable attempt to grow at the cost of other nations.

Pettis argues that because China has seen de facto revaluation as a result of the EURUSD drop, China could buy Euros, lots and lots of them, strengthening the Euro vs the Yuan. The problem I see, and Pettis describes, is that trade deficit countries are trying to lower their deficits or even become exporters, but too many people are trying to do the same thing at once, and China, the country with the largest trade surplus, doesn't want to give part of it up. The scary thing I see here is that depressing one's own currency is being seen as the key to exports and therefore prosperity, but if everyone is playing that game, what we'll be left with is a fiat-currency race to the bottom--something I hope never to see in my lifetime, as I don't like guns or canned food.

In my opinion, what China could to do is develop a larger domestic demand for its products. Playing a little game of this thing that looks like that thing, the current practice of exporting stuff and importing money seems a tad Mercantilist, in my opinion. Maybe instead of exporting stuff and importing money (debt, actually) they could import and export stuff. Or keep more of their goods at home, allowing for a larger accumulation of goods by the Chinese people--after all, value creation is not a zero-sum game. Moreover, I firmly believe that the people of China would be better served by working on their country instead of building us trinkets. By that, I mean that the marginal utility of undertakings like education (child and adult alike), immunization, water-treatment, waste disposal, infrastructure improvements and investments in whatever increases quality of life is higher than that of factory work making trinkets for sale in the US. Sometimes I really wonder if policymakers understand that the best and most sustainable path to increasing your wealth is not to take someone else's, it's to create your own.

Chinese money-supply April update

To see the latest data please see the label Chinese Money Supply 

The Chinese money-supply data for April has been released. While it shows no further increases in the rate of growth, with YoY growth levels steady from March, it still shows significant expansion. The M1 measure showed a 31% YoY growth, a decline from its record-setting 39% in January, but still quite elevated; M2 growth dropped by 1% MoM to 21%, down 9% from its October record of 30%; M0 continued its increase at 16%; and the Money Multiplier increased 0.03 points to 5.9, an all-time high. The increasing MM is indicative of a continuing increase in lending, even as reserve-requirements increase (more below) and corroborates the "property bubble" story, but can not be considered evidence. What is clear from this is that there is still increasing demand for loans. While the numbers are nothing radically different from what we've seen in the last couple of months, the M0 growth is quite elevated and indicative of loose monetary policy, a little surprising considering the tightening--via reserve requirement increases--in January and February. It'll be interesting to see the May and June numbers considering the additional increase in reserve-requirements in May, as the numbers do indicate a heated economy.

Please note that, purportedly because of demand for physical cash money, there is a significant distortion around the Chinese New Year.

2004-2007 Redux: Crisis officially wasted, history on schedule to repeat

Revealed: The home loan that could save you a fortune:

ING Direct, Australia's fifth largest lender, is preparing to sell loans that have no fixed term and no requirement to repay any capital along the way.
...
Repayments would be kept to a minimum, allowing borrowers to benefit from capital growth in their property.
"People are needlessly being denied the chance to buy a property while prices spiral rapidly out of their reach" ING Direct CEO Don Koch said.
"There is an urgent need to provide more affordable options and borrowers should be able to choose whether they want to repay the capital, or not."
Mr Koch wants to position the bank as a "mortgage partner for life", with borrowers carrying the same interest-only loan from property to property for as long as they wish, accumulating equity from rising house prices as they go.

Remember how well this worked for us? For what it's worth, the correct way to never have to repay capital is to rent. This sounds more like indentured servitude than progress. Next thing you know we'll be voting-in feudalism. This is totally going to end in tears.

Offtopic: Cocktails for Two - Joy

Required listening: "Joy to the world meant a beautiful thing, but to me it meant nothing but sorrow"

On Koo: Using Stimulus to Avoid Deflation

I recently finished reading The Holy Grail of Macroeconomicsby Richard C. Koo, and incredibly well-thought out, if slightly repetitive, account on what he calls Balance Sheet Recessions. You might recognize his name since he's been in the news recently. I loved the book, even though I am sure he could have written it in half the pages. I've been waiting to write about this topic until I have the time to write a book review about Holy Grail, but I can't let Perfect be the enemy of Good here. Basically, Koo explains that after an asset-bubble implosion, the private sector is stuck holding assets which are worth less than the debt used to buy them, like the "under water homeowners." When this is the case, Koo argues, businesses will focus on paying down debt as fast as possible at the cost of profit maximization because they are technically (close to) insolvent, that meaning liabilities outweigh assets. During these times of no credit demand, monetary policy becomes impotent and businesses will refuse to borrow, no matter how long the interest rate, leading to a shrinking money supply, or deflation. I am not going to argue about whether deflation is a good or bad thing, but Koo explains that if a government wants to avoid deflation, it should become the borrower of last resort and borrow excess funds from the private sector to use as fiscal stimulus, therefore staving off deflation.

His thesis is well documented, to the point where you want to scream, "OK! I GET IT! JUST PLEEEEASSEEE MOVE ON!" It is hard to argue against it, since it does make sense. The problem with it is that Koo--wrongly, in my opinion--assumes that the Government will adequately allocate that capital. According to Koo, the excess savings from the private sector deleveraging, combined with accommodating monetary policy from a central bank, will keep borrowing costs low until the private sector recovers and starts borrowing again, at which time the government should start to scale back stimulus letting the private sector take over. Koo argues that the growth in the debt have little effect because borrowings will be financed at low rates and, as the economy recovers, tax-receipts will organically increase, leading to deleveraging in the public balance sheet as the private one releverages.

While Koo's is an elegant model, I have some bones to pick. First of all, Koo is proposing a solution to a problem--he's giving us insecticides to kill our pests. While I welcome his contribution, it doesn't mean that we shouldn't still focus on reducing or avoiding asset-price bubbles. As Pettis so eloquently wrote:

By net contingent liabilities I mean the excess of debt over the value of the investment it supports. For example, if RMB 100 is borrowed to build a railroad, the debt is sustainable if the railroad creates net economic value to China of RMB 100 or more. If it doesn’t, the difference must be considered net debt that one way or another must be paid for by Chinese households. This will of course reduce their future consumption along with the economic growth associated with satisfying that consumption.

Pettis may be talking about China, but the issue of mal-investment still applies. The federal government can borrow as much as it wants to stimulate the economy, guarantee Build America bonds, back-stop bank losses and fight tooth-and-nail to fight deflation, but if the capital is poorly allocated, it may be creating a bigger problem than it started. Fighting asset-price bubbles starts with making sure interest rates are not negative. Greenspan enacted used monetary policy to stimulate the economy after the .com bubble and, as Koo explains Chapter 7, started inflating " the housing market, the most interest-rate-sensitive sector of the economy." Well, look how that turned out.

I am not saying that deflation is a good thing, but I am saying that if the stimulus is applied incorrectly, it could just make problems worse down the road because, while stimulus may make everything rosy in the GDP = C + I + G +NX model, it doesn't take into account value. That is, it uses the GDP as a proxy for value created, which may or may not be right. In the end, all these stimulus funds will do is fund projects that will transfer wealth to the private sector by borrowing from the public's future wealth, keeping momentum going. A problem, however, surfaces when the projects undertaken do not create wealth equal to the present value of the debt. You can keep an economy going by paying people to shovel sand from one pile to another but, if we do that, once the stimulus runs dry all we are left with is a couple of piles of sand. I'm not saying the government wants us to shovel sand--they could be building the next Eisenhower Highway System for all I know--I'm just not comfortable leaving that decision up to the guys that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin.

As a final clarification, this is not an attack on Koo, not even close. I just think we should question whether we can trust the political class to Do The (Economically) Right Thing for all of us, not just their campaign donors.

Previously, in Angry Rants:

If we ever hope to get back to growth and increasing standards of living we can't all just sit around trading shit back and forth, we need to reduce our speculative activities and get back to funding and working on value creating processes.

Yikes! Overbought much?

I have a small ADR position from a European exchange where I didn't hedge my Euro exposure, mostly because I needed to learn this lesson the hard way. The position was too small to hedge using futures, I had no access to borrow in EUR and I was being cheap about the tickets and the drag from shorting a Euro bond ETF given the steepness of the curve. Ouch! Lesson learned.

California is a Third-World State

On March 22, 2010 Mercury news published an article detailing some tax changes in the state of California:

The deal reached Monday provides $200 million in new tax credits for homebuyers, to be split evenly among those buying a home for the first time and anyone buying a newly constructed home. Anyone qualified who makes a purchase between this May and August 2011 will receive a credit for 5 percent of the home's purchase price, up to $10,000 over three years. (MB: This is in addition to federal tax credits)

It is no secret that CA has had it's share of budget woes. From the issuing of IOUs, to the $20 billion deficit, it hasn't been easy for CA to get it's finances in order. That's why this measure seemed a little backward to me at the time, especially considering the low efficacy of the federal program and the record-high unemployment rate of 12.6% and associated fiscal woes CA was facing. I understand the government wants to stimulate demand for housing, but as Bill at Calculated Risk said, they should have really focused on stimulating house-hold creation, preferably via jobs which create additional tax revenue as well. This short-lived scheme will only help to accelerate the turning of renters into buyers, depressing rents and leading to lessened demand for investment properties. Rather than trying to revive a housing boom that isn't coming back, the government should have focused on helping unemployed workers gain new skills so that when the economy recovers they are ready to get back to work, because it looks like they are going to need it.

Because you can't spend your way out of a debt problem, California's budget problems persist. Today, the Governator proposed violent cuts to welfare programs, including welfare-to-work, child-care, and medical aid for the elderly. I would be surprised if these cuts weren't just empty threats like "give us bailout or we'll just have to fire all the teachers," but it outlines the bigger problem at hand: California is suffering from some delusion of entitlement and refuses to live within its budget. It is simply unconscionable that they are getting $3.2 billion from the federal government and giving away $200 million of it as a de-facto stimulus payment to the people doing well enough to buy a house while trying to cut child-care programs. Naturally, the Democrats are now calling for increased taxes because nobody wants to take the unpopular action of cutting anything. The pain must be shared, though. You won't attract employers by raising taxes and taxing the workers will just reduce the attractiveness of the state. If they are going to be successful in getting their budget under control, it will have to be a balance of increases in taxes, decreases in social programs, cuts in wages and benefits, an end to wasteful giveaways and an investment in the human capital of the state. If it's in the cards, the future pensioners should share in the pain too, but I don't see that happening.

In my opinion, the Governator is just kicking the can down the road and delaying the problem, hoping that the feds come in at the last second and save the day with a California bailout but, considering the resistance we've seen from Washington to take-on the state's liabilities, I wouldn't plan on it. There is easy things in life and there is hard things; this is a hard thing, and there's just no way around it.

Why I can't stand Nassim Taleb

I am fucking done with Taleb. I read The Black Swan and Fooled by Randomness and I liked them. I didn't necessarily like his tone, but I liked some of his ideas and, while I felt a little bit condescended on, it did get me to think about certain things I hadn't thought about before. Then I read The Aftermath of War, The (Mis)Behavior of Markets and some assorted Karl Popper and realized that Taleb is just a gigantic douche that kind of misses the point of all these great philosophers he claims to be so enamored with. The fact that he is some gigantic show-off that talks his book and brags about his good plays--while never, ever mentioning the bad ones--doesn't really bother me. He used to be a trader, what can you expect from him? What really kills me though, is that he has so much influence on people. It's easy to get caught up in his little stories, but, once you bring them to the real world, they just don't hold. Newcomers like his simple no-nonsense approach that traders are stupid and you can make a ton of money by just being less stupid--it makes them feel empowered--but the reality is there is no easy money.

While his points regarding the failure of statisticians to accept that sometimes markets can't be modeled and trying to do so is futile makes total sense to me, his talk of using OTM options to profit from fat-tail events is nothing new, and completely ignores how options are actually priced. You'd think the author of Dynamic Hedging (a great way to learn options, actually) would understand the volatility frown/smile and skew. If his thesis was really right you could just buy highly levered front and back spreads simultaneously (a "W" shape R/R profile) and let play those forever, hoping to eventually cash in on a tail event. I'll save you the trouble, the back tests (post '87 crash, when fat tails began being priced in) don't exactly show this one to be a big winner. You'd also think a statistician would understand (less than) zero-sum games. Finally, you'd would hope someone with that much education in financial markets to have at least some vague inkling of the concept of value and value creation/extraction/destruction. He could learn a thing or two about that Pettis article I linked yesterday.

Then there is his wanna-be philosopher, Roubini-humping act; it's getting really old. The reality of it is that he's a washed-up trader working in academics and trying to ride Roubini's coat-tails. I may find Roubini insufferable, but he's a smart man that makes great, insightful points, even if I disagree sometimes. Roubini is also trying to, in addition to making money, make a difference and point-out problems, purportedly so we can fix them. What the fuck does Taleb bring to the table? He's just another asshole trying to make a dollar off of your labor. Go on SSRN and search his name and see what you come up with. Look at his twitter, where he tests out his "aphorisms/epigrams." and then try to figure out where he's adding value to the chain. Just look at these examples:

BusinessBookReaders with my prose are like deaf persons in a Puccini opera: they may like a thing or two while wondering "what's the point?"

The characteristic feature of the loser is to bemoan mankind's flaws, biases, & irrationality --without exploiting them for fun and profit.

Stimulus w/ deficit, even if effective, is as immoral as borrowing from your grandchildren (without asking them) to repay your gambling debt

You will be civilized the day you can spend time doing nothing, learning nothing, & improving nothing, without feeling slightest guilt.

Real philosophers require only long walks to figure out what mere people need crises, accidents, serial bailouts, & calamities to understand

Aha! How witty, that philosophical truth! C'mon. Taleb is a philosopher in the same way the drunk sophomore at some college bar trying to diagnose you is a psychologist. The difference being that the drunk girl intents to actually continue her education and will one day probably be a real psychologist. Taleb will never be a philosopher, he's just a philistine looking for money and attention. You know how it's just so-easy to roll your eyes at The Tipping Point and think "congratulations on learning about exponential growth curves"? Nassim Taleb is basically the Malcom Gladwell of his genre--which gets a little circular when you consider Outliers is just a rehash of the same ideas in The Black Swan, which is basically just a really long "Accept the possibility that what you know may be wrong and or incomplete."

Finally, I'm just going to quote Falkenstein, who's risk/return paper should should have read at least three times by now:

Gee, someone should write a book about blow-hard traders who misrepresent their track records and take excessive risk with other-people's money, all due to cognitive biases they are too shallow to notice in themselves. Oh yeah, Taleb has done that! I guess his insider status gives him better insight.

Look, I could go on about how insufferable I find this man for another 500 words, but I'll summarize it: He's a man that doesn't give a fuck about progress; therefore I no longer give a fuck what he has to say.

More on the Chinese real estate "bubble"

While reading the comments to M Pettis' excellent latest entry I spotted this:

The loan to value ratio has been between 10-20% from 2005 to 2008, it had increased to 46% in 2009 and further surged to 76% in 1Q10. (I used the incremental increase in mortgage loans from PBoC report and value of commercial residential transacted data from NBS ... I suspect the surge in loan in April further increases this leverage ratio.

I attribute this surge in leverage to two main reasons, 1) speculators have finally realized they can make a lot more $$ if they lever up and the common belief in China is that property prices will keep on going up ... Real demand is forced to lever to buy. To me, this is a sign of the upper bound of the affordibility. (sic)

Ding! ding! ding! If this man is really correct, those are some bubblicious circumstances. And if the LTVs are really as high as the upper 70s, well, 3 words: Balance-sheet recession. This should be really interesting. Outside of that whole thing, Pettis makes some excellent arguments and manages to concisely verbalize thoughts that I could spend hours rambling about and never really get across, so I'll just quote him:

For example, if RMB 100 is borrowed to build a railroad, the debt is sustainable if the railroad creates net economic value to China of RMB 100 or more.  If it doesn’t, the difference must be considered net debt that one way or another must be paid for by Chinese households.  This will of course reduce their future consumption along with the economic growth associated with satisfying that consumption.

Note that net economic value does not mean the total profits of the railroad generated by ticket revenues less operating costs.  We could begin with that number, but the value of the railroad would be increased by associated externalities – i.e. building the railroad might lower transportation costs for a number of businesses, allowing them to grow and to add economic value indirectly.  It would be reduced by certain opportunity costs, for example the alternative use of the land if it had a better use, or the negative impact it might have on the existing highway and airline infrastructure.

But most importantly it would be reduced by distortions in the financing cost.  For example, if the railroad were to be fully financed by 10-year bonds with interest rates 3 percentage points below the “natural” borrowing cost (a very low estimate), the economic value of the railroad would have to be reduced by RMB 19.

This amount is simply equal to the net present value of the hidden transfer from the lender to the borrower.  The fact that the borrower can obtain subsidized funds at an artificially low cost must represent a transfer of wealth from the providers of the funding, and this subsidy is a loss for the rest of the economy equal to the additional value for the entity being subsidized (another way of saying that there is no free lunch*).  By the way if the cost of funding is repressed by 6 percentage points, a perfectly plausible number, the net present value of the hidden subsidy is RMB 34.  These are not small numbers.

 I know that's long, but compared to how much he says, it's not a lot of words. This is the best summary of the problems of cheap credit I have EVER seen. And it's not only applicable to China, it applies to us too! Think about all  the artificially suppressed mortgage rates, the Fed and FDIC backing/guarantee programs, the whole issue of ZIRP etc. There's a ton of liquidity out there and it needs to go *somewhere*. If you lower rates enough, people will start investing in projects with negative NPVs. I know that doesn't make sense, but if you calculate the NPV as the present-value of the probability-adjusted payouts, one might go into a project with the odds against him because you can finance it with a loan, and if it goes bust you can just default. Which is really the problem with ZIRP, that it we end up investing in what essentially is a debt-financed call-option.

This kind of casino capitalism isn't going to get us anywhere. If we ever hope to get back to growth and increasing standards of living we can't all just sit around trading shit back and forth, we need to reduce our speculative activities and get back to funding and working on value creating processes.


PS: I find it fitting that Abnormal Returns (no link for them) linked to this same article when talking about the SSE performance. Way to miss the whole point, assholes. It's fitting that it's part of the "twit" network.

Chinese money-supply growth slows, reserves inch lower

To see the latest data please see the label Chinese Money Supply
 
Hot on the heels of my complaint about the People's Bank of China not publishing money-supply statistics, the numbers have been published to their Chinese-language website, although still no 2010 data in the English-language version. It's becoming clear that there is evidence of overheating, although--as the second graph suggests--the government's efforts in slowing down growth have worked. In particular, the changes seen between Q1-2009 and Q2-2009 are indicative of overheating. Particularly notable, the M1 changes seen in the last 3 quarters signal the credit-expansion I was referring to last time I wrote about China.

The fact that M1 is still growing at an accelerating pace is worrysome. Just today, Bloomberg reported increasing inflation, hot on the heels of monetary tightening over the past couple of months. While this might sound counter-intuitive, it is well-covered by "Charles" on M Pettis' website. Part of his point being that when people are working towards a target sum by a certain date, lowering the discount rate will only serve to increase the savings rate as people have to make up lost interest income, or that when people have most of their savings in bank deposits instead of other assets, a decrease in the discount rate will have a negative wealth effect. That neat little digression aside, the point I am trying to make here is that these cultural differences in saving and spending behavior coupled with fears about declining purchasing-power of money could lead to an increasing demand for hard-assets, leading to additional upward pressure on prices.

For now, though,  I still think the Chinese "real-estate bubble" is a little too hyped up. Their banking rules require lower LTVs and their bank reserve-requirements are higher, making a US-style housing implosion unlikely. Asset prices may drop or stagnate, but I doubt a full-on implosion leading to a banking crisis is possible without the fuel provided by zero-downs, neg-ams etc. What I would love to see is some data as to what % of bank assets real-estate backed loans compromise and their average LTV. If one is to find evidence of a bubble or lack there-of, it'd be there.

Liar vs. Liar

(WSJ Article)

It's not even worth arguing about. I mean, women with breast cancer? Barry-O might as well have accused them of dropping firemen with smoke-inhalation damage. Wellpoint, naturally, sends the female CEO out to deny allegations. It would have been more believable if she had said "Wellpoint does not single out any ill patients for rescission." Remember that time we talked about risk pools? Yeah, this is it.

In the article, the WSJ mentions that Braly says the administration's "attacks" on health insurers "must end." Uhm, they most certainly must not. I'm sure that as a C-level executive of a company in an industry that risks being obsoleted, she is shitting her panties right now, but that doesn't mean anything. I'm sure health-tonic vendors felt the same way about FDA approval. The point is that when the risk-pool is equal to the population, insurers--as they presently--exist are not only not necessary, but become a value-destructing, utility-extracting wheel in the machine.

I'm sure the CEOs are going to be sad they lose their paychecks, as will be the tens of thousands of clerical employees, billing and collections departments, middle management, and assorted paper-pushers, but this is a blessing in disguise. It will free them to do something that actually adds value to the economy, or at least to sit on their asses for 100 weeks collecting unemployment benefits. You could look at it as frictional unemployment, but I like to see it as creative destruction.

Is the Elite Liberal Media instigating panic? (UPDATE-2)

The title is just a joke, although the NYT isn't exactly my go-to when it comes to financial reporting. Anyway, Barry Ritholtz ran the following chart from the NYT today.

Which is cool and all, but by my calculations the debt looks quite different. Granted, this data is like 5 weeks old, but the gaps are so large in some cases that something must be wrong because there hasn't been that much activity in sovereign issues/redemptions. I'll pull up the data on Bloomberg some other time and give you an update, but at first glance, there is something deeply wrong with this graph. Either this is not sovereign debt or someone made a mistake. Maybe they are counting bank debt too? I don't know, but comment if you do. Take in mind NYT is reporting the debt in dollars. Considering EURUSD = 1.27 at time of writing, I think someone fucked up.


By my calculations:

• Ireland is closer to EUR 200MMM or US$254MMM
• Italy is more like EUR 1,050MMM or US$1,335MMM
• Spain is EUR 339MMM or US$430MMM
• Portugal is EUR 97.5MMM or US$123MMM
• Greece EUR 260MMM or US$330MMM

UPDATE-1: I got a reply back from Bill Marsh at the NYT. His reply was so prompt and complete, that I feel bad I even make the joke about them. They really are an exemplary organization. They embrace digital media, new content delivery and monetization and are huge supporters of Open Source Software and open data initiatives. Apologies out of the way, here's what he said

the figures come from this report and are for the end of 2009. the data starts on page 74 and covers all countries (note that the numbers for each european country’s debt-holders are spread across pages 74, 78 and 82).

http://www.bis.org/statistics/provbstats.pdf#page=74

these figures include both government and bank debt. hope that helps!

Mystery solved! The data comes from the Bank for International Settlements. Unfortunately, this isn't such good news, and here is why:

• OK, I lied, there is one piece of good news, the weakening Euro reduces the dollar value of these liabilities, so, in that respect, they are overstated.
• There has definitely been increased borrowing in the part of sovereigns since December 2009, particularly the ones in question which have significant budget deficits. Even the data I posted understates this, since there has been debt placements since then.
• The numbers appear to exclude internal debt, which means total liabilities are actually understated
• With widening spreads and downward rating revisions, banks might have to tighten lending to offset changes capital that is marked-to-market. Although, no big deal since all this stuff can be repoed at the ECB.
• The Euro zone could see capital flight, which would widen spreads and put stress on the banks as assets move, forcing them to either finance their assets with debt or liquidate some of them, putting additional downward pressure on the assets
• That Ireland number is SCARY. Not a lot of it is sovereign debt, a lot of it is bank debt, but that's too-big-to-save territory for the Irish government. If they face another banking crisis, they're going to need to go outside for help. It's $206,429 of debt per-capita!

Compare with: (credit: Marc P @ Big Picture)

• Ireland  $206,429
• Portugal  $26,729
• Spain  $27,160
• Italy  $24,096
• Greece  $22,056
• USA $38,737 

By the way, this is why I hate it when they convert figures to dollars from their original currency. Liabilities and assets should be listed in the currency they are denominated in. Exchange rates are only valid for a very brief point in time, making the data kind of useless or hard to use once that piece of information changes.

UPDATE-2: It has been brought to my attention that the Ireland figure is probably vastly inflated by the debt from financial organizations with operations in the IFSC. My apologies for this glaring omission. (MB - 05/17/2010)

Shut up, bloggers: The Fed is full of eeeediots & "Secret-sauce" sell-in-May porfolios

I read quite a few finance and economics blogs, many more than the list on the right would have you believe, and while they are really good for the most part, sometimes people make mistakes. Today I call out two people on their mistakes: Barry Ritholtz of the excellent The Big Picture and Jake of EconomPic Data, who makes some of the better eye candy in the economics blogosphere.

The Fed is full of Eeeeediots
This morning, Barry called the economists at the Federal Reserve innumerate.  As someone who has a decent grasp on numbers and studied economics, I resent that. Listen here, Ritholtz, the .com bubble was a no-brainer in 1999 and late 1998 and the housing bubble was obvious in 2005/2006 when even the Gawkerites had that long running joke about never being able to afford a brownstone in Brooklyn and "Flip This House" was a hit TV show. That all was straight out of "Extraordinary Popular Delusions and the Madness of Crowds" but calling a nascent bubble in 2003/2004 wasn't so simple. I like to rag on timmay, benny, hankay and the maestro as much as anyone--although never Volcker, he's my boy--but they are not stupid, much less innumerate. Their version of  Do The Right Thing might differ from yours and mine, but we are just going to have to accept that since we can't vote for Fed chairmen ourselves.

Also, remember in 2004 Greenspan started to move towards higher rates, with 17 hikes? By 2005 the yield curve went inverted. I remember because I was in undergrad Money and Banking at the time and my teacher, an insufferably monotone man, was basically doing back-flips in excitement, telling us all about how special a moment that was and how we should consider revising our portfolios because he expected a recession.  Well, the point is the far end didn't move up. Whether it is because of what Koo calls "debt rejection syndrome" or not, I' don't know. The point is that the Fed DID move too cool down credit-fueled speculation but, if you believe Koo, the monetary approach was impotent. The Fed did the right thing, albeit too late and with tools that didn't work. Hindsight 20/20 etc. If you want to hate on the Fed and The Beard, maybe you should poke fun at His Beardedness' suggestion that the BoJ buy Ketchup, like Koo did. Yeah, Koo again. Goddamnit Barry, why can't you be more like Koo?!?!?! (j/k, you are much entertaining and your books was much more fun to read)

Sell in May and go buy secret-sauce bonds?
Today, Jake posted a graph of what would have happened if you invested in this instead of that. I hate those graphs, they are remarkably useless 99.9% of the time and are just screaming DATA MINING. As a fellow economist, I expected more from you Jake.

Seriously guy. Look at how that interest-rate graph behaved and look at how the secret-sauce portfolio started outperforming in the mid 80s when interest rates were coming down from all-time highs. Of course holding on to fixed income instruments at a time of dropping rates is going to result in gains, duh! Try the experiment again with floaters, callables or anything with negative convexity and see what happens. My guess is it won't be quite as spectacular. Try it with full-year "secret sauce",  or zero-coupons for the Summer and watch your fake portfolio make. it. rain.

This thing that looks like that thing: Greek bailout Edition (UPDATE-1)

A little over a week ago, Peter and Simon over at the Baseline Scenario wrote the following:

To restore confidence in buying Spanish and other major European nation bonds, it would surely help to have clear signals that President Obama himself, and the Federal Reserve, are taking an active stance now on making sure this does not spread to become another threat to global financial stability. A broader wall of preventive financing must now be put in place – after all, this is exactly why (in principle) the IMF was recapitalized this time last year.

Then Greece got a bailout of EUR 110MMM, but there was still trouble and John Mauldin wrote:

...30% of the Greek financing will come from the IMF ... and since 40% of the IMF is funded by US taxpayers, and that debt will be JUNIOR to current bond holders ... US tax payers will be giving money to Greece who will use a lot of it to roll over old bonds, letting European banks  and funds reduce their exposure to Greece while tax-payers all over the world who fund the IMF assume that risk. And does anyone really think that Greece will pay that debt back?

As if it wasn't enough that the ECB went back on their word and is allowing GGB to be repoed for liquidity regardless of the rating--this is the part where the ECB engineers a super-steep yield curve to transfer depositors money to bank balance sheets--now they are going to monetize the Euro debts.

I told you they were going to take your money. Let's file this one under, "this is not progress," shall we?

UPDATE-1: The WSJ reports that the US share of this is actually more like 17% and so we are only on the hook for $3MMM or so.

The Possibility of a Chinese Propety Bubble and its Monetary Challenges

I have previously reported on the Chinese money-supply, but have not done so lately because the Peoples Bank of China has not reported money-supply information since January in their Chinese-language statistics page, and have not reported any statistics for 2010 in their English-language statistics page. This makes it exceptionally frustrating to hear about asset-price bubbles happening in the Chinese property market. Part of me really wants to believe the hype, because the increasing reserve requirements indicate monetary tightening and an attempt from the PBoC to cool down lending, but I would like some hard evidence.

As long as there is strong demand for funds by households or businesses, monetary tightening will raise interest rates, which should be able to cool down speculative activity. The problem here is that a globalized financial system means that rate increases could very well lead to large capital inflows as American, European and Japanese investors reach for yield since their respective central banks are keeping interest rates depressed. Compounding this problem is all the talk there has been about Yuan appreciation.

The reason that using rising rates to slow-down excessive speculation combined with expectations of a stronger Yuan is dangerous is that if low-interest rate country investors move money to China chasing yield, it will create added demand for the Yuan and excess supply for the home currency. In large enough quantities, this same pressure could put additional upward pressure on the Yuan compared to the Yen/Dollar/Euro. If the Chinese authorities crack to US pressure and allow appreciation of the Yuan, then this move up would only reinforce this behavior, creating a self-feedback loop, or, as it is otherwise known, a self-fulfilling prophecy. This is not an academic scenario, carry traders have systematically depressed the Yen and strengthened their target currencies for years with New Zealand being a prime example. If you are interested in the subject I highly recommend the last 3 chapters of The Holy Grail of Macroeconomics, Revised Edition: Lessons from Japans Great Recession.

Additionally, rising rates in China coupled with a strengthening currency would only serve to fuel an asset-price bubble, as money pouring into China seeks an asset to be parked in. If it's not foreign money, it could very well be local businesses borrowing abroad. I am not familiar with the specifics of the Chinese monetary policy, but depending on the amount of restriction there is with regards to borrowing abroad, it would be attractive for businesses to borrow at depressed rates in Japan or the US and use it to buy property in China. In addition to paying a lower interest-rate, Yuan appreciation would mean that dollar debts would be reduced in Yuan terms, driving the already low borrowing costs even lower, reducing the cost of carry and driving ever more speculative investment. This could continue until the PBoC either succeeds in cooling down a booming property market or the whole thing collapses onto itself. While the first option could create a small garden-variety recession, the second option would create huge losses to the people of China, create a violent swing in the exchange rate and push china into a balance-sheet recession.

If the MSM writings on China are correct and businesses are making speculative property investments with borrowed money, this has the potential to be a giant balance sheet recession in the making; however, if the purchases are not significantly leveraged, losses are likely to be absorbed by owner equity instead of a US-style housing bust where NPLs quickly spread to banking system and lead to a credit crunch and full-on systemic crisis.

Until I can find official numbers on the amount of real-estate financed with debt, I won't know if there really is a Chinese real-estate bubble or the magnitude of it. Until then, though, I will keep watching both the moves of the PBoC and Yuan for clues as to the presence of a bubble. A refusal of the Chinese authorities to allow Yuan appreciation wouldn't necessarily be a case of "mercantilist" policies or export subsidy as much as it could be the Chinese trying to prevent further asset-price increases resulting from capital inflows.