Thursday, August 25, 2011

Do you think Ron Paul, Michelle Bachmann, and Rick Perry are idiots? Would you like to bet on it? Tomorrow is your lucky day.

Since my last post there has been quite a bit of excitement in the markets. The S&P 500 has had about a 10% range and has been moving at least a percent a day, often much more. Given these massive moves its hard to ascribe a lot of meaning to the market action on any given day. That said I think fundamentally three things are at work. One, is that the markets are still getting used to the idea that there is no risk free rate. This is a complicated fact for the markets to absorb given how much portfolio theory and how many pricing models rely on this assumption. That said, its a very subtle impact and the markets seem to have adjusted by fleeing relatively risky assets and piling into relatively less risky ones.

The second story is the Eurozone crisis. Though the ECB has, for the time being, successfully pushed back a speculative attack on Italy and the attack on France in light of the US downgrade has also receded most investors are aware that there remain very deep and vexing problems in the Eurozone. Though many of the consequences of a sovereign default of a major country are unknown they would almost certainly lead to a major banking crisis which would be nearly impossible to contain. Though the markets don't know what the probability of this is they know the consequences are very very bad and this fact is weighing heavily on the markets. More on this in subsequent posts.

What optimism there is stems from two things. One is the hope that though the economy is slowing down the market reaction has been overdone and that the economy and with it the markets will pick up, of on their own in the second half. The other reason, and according to some pundits, by far the stronger, is the idea that the Federal Reserve is going to ride to the rescue. This is because Ben Bernanke is set to give a speech in Jackson Hole at the Kansas City Fed conference of Central Bankers on Friday. It was at this conference a year ago that Ben Bernanke announced that he was embarking on a second round of quantitative easing, or as it has been affectionately called: QE2.

Now the Quantitative Easing policy has been controversial to say the least. Where you stand on this controversy will say a lot about whether you think Bernanke will announce further easing on Friday. Virtually all of the Republican Presidential candidates have come out against Quantitative Easing. Just last week Rick Perry called the policy “treasonous.” Ron Paul, who has made himself heard on this subject repeatedly not only opposes Quantitative Easing but the entire Federal Reserve System and, for good measure, the whole concept of fiat money. Naturally someone who believes that we should return to the gold standard is not going to be a fan of creating reserves in the banking system and using them to purchase Treasury bonds with them. Michelle Bachman has also come out against Quantitative Easing though, if you ask me, not with a particularly coherent objection. It may be silly to call a monetary policy tool “treasonous” but at least you know where the guy stands even if his reasoning can best be called “obscure.”

It is worth taking a look at the arguments that these men and other opponents of QE make because, whether you agree with them generally or not, there are indeed good arguments to be made against it. Opponents of QE have two main objections. The first is that QE is an enabler of government profligacy. That is to say that the fact that the Federal Reserve is creating reserves (printing money) in the banking system and using those reserves to purchase US government securities is creating artificial demand for those securities and as a result is lowering the cost of borrowing for the government. This of course just encourages the government to borrow more than it would otherwise. While it is true that QE does marginally lower the rates at which the government borrows it is not clear to me that it follows that this creates more borrowing. The level of government borrowing is a function of the budget process which is well in the hands of congress and I don't think that the level of interest rates has been of much concern to Congress with regard to those decisions for at least a decade. In any case, even without QE interest rates are at a level which would be unlikely to deter borrowing anyway so I think this is a weak argument.

A more compelling argument is that money creation is well known to be inflationary. Historically countries which have found themselves creating money in order to finance public spending often fall into an inflationary spiral which often has devastating consequences for the country. This is because the artificial creation of money in the hands of the state tends to devalue all the real goods and services in the economy in terms of that currency. That the more money there is the lower its value in terms of actual goods and services and therefore the price of everything goes up. This erodes the savings of the thrifty and devalues the debts of the levered. It also causes massive dislocations in the economy generally. Latin America is littered with examples of this and the recent example of Zimbabwe going over the hyperinflation cliff has once again served as a warning to the world. Of course the most politically momentous monetization of government obligations occurred in Germany in 1922. The subsequent hyperinflation obliterated and then radicalized the German middle class and laid the groundwork for the capture of the state by the Nazi party. So to say the least, the historical record for debt monetization (printing money to finance government spending) is not great.

So the Tea Party guys are not crazy to raise objections to quantitative easing. Given that they think the primary motivation behind it is to facilitate additional government stimulus when the economy slows down it is not hard to imagine why they might think that a fresh wave of it is on the way. GDP growth has been much slower than planned, consumer sentiment is weakening and many economic indicators have come in much weaker than expected or hoped. A few weeks back the Fed revealed that its outlook for the economy has darkened significantly and announced that it would maintain its extremely low interest rate policy through 2013. Given this, it is easy to see why many people expect some kind of announcement of further policy action by the Fed come this Friday and since they hate the idea they are up in arms. On the other hand, stocks are priced in dollars and so, in the event that the Fed announces QE3, their prices are likely to rise which is why many think we have come off the bottom despite continuously grim economic data.

Personally I have a different view of this. While I am not a fan of printing money generally and I am very aware of the historical record I think that, at least in the hands of Ben Bernanke, Quantitative Easing is not to be feared. The reason is that Bernanke had a very specific reason for engaging in QE last year that had nothing to do with a desire to fund the US Treasury more cheaply. The thing to remember is that just as money can be created it can also be destroyed and what Bernanke was doing was making up for monetary destruction.

As mentioned the Federal Reserve Bank creates money through quantitative easing but because the US banking system is a “fractional reserve” banking system the commercial banks are able to create money as well in the course of taking in deposits and making loans. This is because they are only required to hold some of their deposits in reserve (ergo “fractional reserve.”) This is why banks are able to operate with such extraordinary leverage. Banks are also required to have an adequate equity capital cushion in the event of losses so that the equity holders take the losses before the depositors do.

The trouble is when banks take a large losses over a short span of time as they did during 2008 they erode that equity cushion and this means. Since the equity cushion has to be repaired before banks can engage in new money creation large losses shrink the money supply. This is why the Fed embarked on QE1. So the collapse in housing prices has forced the banks to take recognize huge losses on their balance sheets but, as large as those losses are, the markets believe (and are probably right) that there are still far more losses yet to be taken. A year ago this fear and the weakening of the US economy led people to believe that there would be so much monetary destruction that there in the future not only would we not have inflation, we would have its opposite, deflation. Now, as bad as Ron Paul and Rick Perry think inflation is, the thing that scares the hell out of Ben Bernanke is deflation.

This is a little counterintuitive. It's easy to see why inflation is bad, if you want to buy something and the prices are always going up and going up fast its easy to see how this harms you. On the surface it seems that a world in which the prices of everything were always going down would be good, everything is always cheaper so one can buy more of it with the same funds, everybody wins no? No. The thing about deflation is that it doesn't so much function as a permanent sale but as a permanent deterrent to every buying anything. Imagine if everything in the world was always getting cheaper, then you would only buy the things you absolutely needed right now and you would defer all other purchases. Deflation is a HUGE buzz-kill for economic activity. Not to mention that it has the effect of obliterating the solvency of large debtors and the US government is the largest debtor on Earth.

So, seeing deflation on the way last year Ben Bernanke warmed up the printing presses and launched QE2. This sent the stock market higher and whipped cured the deflation problem well and proper. So here we are in the future and not only is there no expectation of deflation, people are concerned about inflation. If the Fed were to engage in Quantitative Easing right now the fears of Ron Paul and Rick Perry and the hopes of the stock market would be fulfilled. This is what gives you an opportunity to bet against Ron Paul and Rick Perry. If you think Ben Bernanke is just part of a nefarious plot to load up the country with debt then you'll probably think he'll embark on QE3 tomorrow and if you do think that you should buy the markets with both hands. If you think that Paul and Perry are all wet and there's no way that Bernanke will do any such thing then you might want to be short going into Bernanke's speech tomorrow. Well, Bernanke speaks at 10AM New York time tomorrow so you'll have 30 minutes to place your bets.

No comments: