Wednesday 28 July 2010

Stagflation à la 70s redux?

"Bank of England's Mervyn King warns over inflation."

No way? Really...

This is a title from an article published today's in the Telegraph as per below's link.

“There will come a point when we will certainly need to ease off the accelerator and return Bank Rate to more normal levels,” Mr King told MPs today.

Given the very weak saving rate in the UK and the high level of private debt and the still ongoing deleveraging, this would lead to another double dip and additional pressure on housing prices to the downside. Mr King is fully aware of the risk but given his current mandate, at some point he will have no choice but to raise rates. It cannot be avoided.

Back in April an even in March I stated that the only result that would be gained by the use of QE would be inflation down the line.

It was obvious then and more obvious now.

Mr King also added the following in this article:

Mr King also suggested the US has been wrong to prioritise growth over cutting debt levels.

"All countries need to have a credible medium term plan within which they can demonstrate that they will get back to a position in which structural deficits are eliminated and there is a sustainable path for the long-term public finances," he said.

Structural deficits need to be tackled now, not only in the US but in the UK, France, Portugal, and all European countries which have been living beyond their means for too long, relying on cheap credit and the complacency of the markets. Make no mistake, the bond vigilantes are still out there and although some of the problems have been kicked down the road, for Greece for example, the problems are yet to be solved as highlighed by the sour recent discussions between the IMF and Hungary in relation to their proposed austerity measures which are not enough.

As a reminder:

MV=PT as per Irving Fisher's equation. The Bank of England bought 200 Billions worth of long dated Gilts with QE. The BOE by pumping M (M4) is expecting T to rise and it is not really happening...
MV = PT. M is the stock of money in the economy,V is the velocity of circulation or the speed at which money flows around the economy. P is the price level and T the value of transactions, or gross domestic product (GDP). Hence by
increasing ‘M’, QE aims to increase ‘T’.

The main risk of QE was that the money pumped into the system would not result in higher
spending and economic activity
. Banks are currently using all these additional funds to help repair balance sheets. Increased availability of credit is not resulting in more lending. Many companies and individuals do not want to increase borrowing during a period of economic uncertainty and this is the reason why savings are going up and people are trying to repay their debt.

Therefore the initial MV = PT equation means that a rise in ‘M’ leads in reality to a fall in ‘V’ leaving no net benefit.

On the 30th of January I warned about the risk of Stagflation 70s style.

Keynes clearly understood the risk of QE and the effects of debasing your currency.

The temptation of reducing the debt burden by increasing inflation is clearly in the mind of our politicians.

We are still in a deflationary environment.

Deflation then inflation. Low growth and high unemployment whith a rise in inflation will led to stagflation at some point. No doubt about it.

It is not only a UK problem.

As highlighted as well by Ambrose Pritchard-Evans in the Telegraph recently, it is affecting India as well:

India's current inflation stands at 11%.

"Maya Bhandari from Lombard Street Research said New Delhi had been far behind the curve in tackling price pressures. The central and regional budgets are heavily in deficit and this is being "monetised" by central bank policy. The inflation rate for primary articles has reached 16pc. "This is not far from British inflation just before the bitter stagflation years of the later 1970s," she said."

China is also facing similar prospect due to overcapacity and price controls.

Back in January I quoted Keynes in relation to the negative effect price controls can have on triggering inflation:

Price controls discourage production.

"The presumption of a spurious value for the currency, by the force of law expressed in the regulation of prices, contains in itself, however, the seeds of final economic decay, and soon dries up the sources of ultimate supply. If a man is compelled to exchange the fruits of his labors for paper which, as experience soon teaches him, he cannot use to purchase what he requires at a price comparable to that which he has received for his own products, he will keep his produce for himself, dispose of it to his friends and neighbors as a favor, or relax his efforts in producing it. A system of compelling the exchange of commodities at what is not their real relative value not only relaxes production, but leads finally to the waste and inefficiency of barter."

Stagflation can not only happen because of the rise of short supplies of commodities like oil in the 70s, but can be caused by a rise in the money supply, due to QE for example.

To conclude I encourage you to read the latest article published by Doug Noland in Asia Times in Credit Bubble Bulletin:

Enjoy the summer and enjoy the read!

You cannot bring about prosperity by discouraging thrift.
You cannot strengthen the weak by weakening the strong
You cannot help the poor man by destroying the rich.
You cannot further the brotherhood of man by inciting class hatred.
You cannot build character and courage by taking away man's initiative and independence.
You cannot help small men by tearing down big men.
You cannot lift the wage earner by pulling down the wage payer.
You cannot keep out of trouble by spending more than your income.
You cannot establish security on borrowed money.
You cannot help men permanently by doing for them what they will not do for themselves.

written in 1916 by the Rev. William J. H. Boetcker, a Presbyterian clergyman and pamphlet writer

Thursday 22 July 2010

"I promise to pay the bearer on demand..." - Panics and Populism.

From the Bank of England's website:

"The words "I promise to pay the bearer on demand the sum of five [ten/twenty/fifty] pounds" date from long ago when our notes represented deposits of gold. At that time, a member of the public could exchange one of our banknotes for gold to the same value. For example, a £5 note could be exchanged for five gold coins, called sovereigns. But the value of the pound has not been linked to gold for many years, so the meaning of the promise to pay has changed. Exchange into gold is no longer possible and Bank of England notes can only be exchanged for other Bank of England notes of the same face value. Public trust in the pound is now maintained by the operation of monetary policy, the objective of which is price stability."

Indeed in a deleveraging and restructuring world, the promise to pay the bearer has changed.

Public trust has been seriously impaired in the latest financial crisis, in both the financial sector as well as in trust in elected governments in general and politicians in particular.

The difficulties of imposing drastic austerity measures in numerous European countries are indeed endangering democracies. General strikes are on the rise in many European countries, France, Greece, Spain, etc.

The rise of populism is a stark reminder of the impact of economic crisis on fragile democracies as seen in the 30's in numerous European countries which led to the Second World War.

Populism in Latin America has had important impacts.

Populism has been fiscally supported in Latin America during periods of growth such as the 1950s and 1960s as well as during commodity price booms such as in oil and precious metals, which also explains today how Chavez in Venezuela is able to maintain his grip of the country. The fate of Chavez is intimately linked to the price of Oil.

Highly unequal societies leads to a rise in populism.

It is a global trend.

From Latin America, to Europe and the US, populism is dangerously rising.

Populism movements are deeply correlated to Panics and Depression throughout human history.

The emergence of the Tea Party movement in the US in 2009 is reminescent of the rise of the Greenback Party, which was active between 1874 and 1884, following the US civil war.

The Greenback Party was born because of the Great Depression of 1873:

"The Panic of 1873 or Depression of 1873 marked a severe international economic depression in Europe and United States that lasted until 1879, and even longer in some countries. It began with financial failures in Vienna (capital of Austria–Hungary then) that spread to most of Europe and overextended American banking in late 1873. It was one of a series of economic crises in the 19th and early 20th centuries. In Britain, the result was two decades of stagnation known as the "Long Depression", during which Britain lost its world economic leadership. In U.S. literature this global event is usually known as "Panic of 1873", while in Europe it is known as Long Depression or Great Depression."

Effects in the U.S.
The failure of the Jay Cooke bank, followed quickly by that of Henry Clews, set off a chain reaction of bank failures and temporarily closed the New York stock market. Factories began to lay off workers as the United States slipped into depression. The effects of the panic were quickly felt in New York, more slowly in Chicago, Virginia City, Nevada and San Francisco.

The New York Stock Exchange closed for ten days starting September 20. Of the country's 364 railroads, 89 went bankrupt. A total of 18,000 businesses failed between 1873 and 1875. Unemployment reached 14% by 1876. Construction work halted, wages were cut, real estate values fell and corporate profits vanished."

Sounds eerily familiar doesn't it?

From the same Wikipedia document we learn about the impact this crisis had in both Germany and Austria.

Germany and Austria:
A similar process of overexpansion was going on in Germany and Austria, where the period from German unification in 1870-71 to the crash in 1873 came to be called the Gründerjahre or "founders' years". A liberalized incorporation law in Germany led to the founding of new enterprises, such as the Deutsche Bank, as well as the incorporation of established ones. Euphoria over the military victory against France in 1871, combined with the influx of capital from the payment by France of war reparations, encouraged stock market speculation in railways, factories, docks, steamships - in short, the same areas of overexpansion as in the United States. It was in the immediate aftermath of Bismarck's victory against France that he began the process of silver demonetization. The process began on 23 November 1871 and cumulated in the introduction of the gold mark on 9 July 1873 as the currency for the new united reich to replace the silver coins of all the constituent parts. Germany was now on the gold standard. Demonetization of silver was therefore a common element in the crises on both sides of the Atlantic Ocean.

On May 9, 1873, the Vienna Stock Exchange crashed, no longer able to sustain false expansion, insolvency, and dishonest manipulations. A series of Viennese bank failures resulted, causing a contraction of the money available for business lending. In Berlin, the railway empire of Bethel Henry Strousberg crashed, bursting the speculation bubble there. The contraction of the German economy was exacerbated by the conclusion of war reparations payments to Germany by France in September 1873. Coming two years after the founding of the German Empire, the panic became known as the Gründerkrach or "founders' crash".

In Britain the long depression resulted in bankruptcies, escalating unemployment, a halt in public works, and a major trade slump that lasted until 1897.

The Austrian Business Cycle Theory I reviewed in a previous post is a very good explaination of the recent crisis as well as the previous ones:

The over expansion of credit and loosening of credit standards seem to always led us to economic crisis.

The panic of 1873 was followed by a similar panic in 1893 in the US.

Similar to 1873, the crisis was caused by railroad overbuilding and unsound railroad financing which led to a series of bank failures. Compounding market overbuilding and a railroad bubble was a run on the gold supply and a policy of using both gold and silver metals as a peg for the US Dollar value. Until the Great Depression, the Panic of '93 was the worst depression the United States had ever experienced.

"The 1880s had been a period of remarkable economic expansion in the United States. In time, the expansion became driven by speculation, much like the tech bubble of the late 1990s and the housing bubble of the early 21st century, except that the associated industry was railroads."

And the panic of 1893 was followed this time by another panic in 1907.

"The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis that occurred in the United States when the New York Stock Exchange fell close to 50% from its peak the previous year. Panic occurred, as this was during a time of economic recession, and there were numerous runs on banks and trust companies. The 1907 panic eventually spread throughout the nation when many state and local banks and businesses entered into bankruptcy. Primary causes of the run include a retraction of market liquidity by a number of New York City banks and a loss of confidence among depositors, exacerbated by unregulated side bets at bucket shops."

The panic of 1907 led to the creation of the FED in 1913, the financial system was shored up in 1907 by the intervention of J.P. Morgan and other bankers.

The market overbuilding and the the real estate bubble led to the financial crisis of 2007 which started with subprime.

The Greenback Party:

"The Greenback Party (also known as the Independent Party, the National Party, and the Greenback-Labor Party) was an American political party with an antimonopoly ideology that was active between 1874 and 1884. Its name referred to paper money, or "greenbacks," that had been issued during the American Civil War and afterward. The party opposed the shift from paper money back to a bullion coin-based monetary system because it believed that privately owned banks and corporations would then reacquire the power to define the value of products and labor. It also condemned the use of militias and private police against union strikes. Conversely, they believed that government control of the monetary system would allow it to keep more currency in circulation, as it had in the war. This would better foster business and assist farmers by raising prices and making debts easier to pay. It was established as a political party whose members were primarily farmers financially hurt by the Panic of 1873.

The Gilded Age was an era of political ferment and conflict over the proper uses of governmental activity. The Greenback movement began as a protest against the national system of money and banking that had emerged by the mid-1870s. In particular, Greenbackers condemned the National Banking System, created by the National Banking Act of 1863, the harmonization of the silver dollar (Coinage Act of 1873 was in fact the "Crime of '73" to Greenback), and the Resumption Act of 1875, which mandated that the U.S. Treasury issue specie (coinage or "hard" currency) in exchange for greenback currency upon its presentation for redemption beginning on 1 January 1879, thus returning the nation to the gold standard. Together, these measures created an inflexible currency controlled by banks rather than the federal government. Greenbacks contended that such a system favored creditors and industry to the detriment of farmers and laborers.

In 1880 the Greenback Party broadened its platform to include support for an income tax, an eight hour day, and allowing women the right to vote. Ideological similarities also existed between the Grange (The National Grange of the Order of Patrons of Husbandry) and the Greenback movement. For example, both the Grange and the GAP favored a national graduated income tax and proposed that public lands be given to settlers rather than sold to land speculators. The town of Greenback, Tennessee was named after the Greenback Party about 1884."

In the US the Tea Party movement has been building up following the massive economic recession:
On June 8, 2010, in the Super Tuesday primary election, several tea party backed candidates have won.

"According to president of the American Enterprise Institute, Arthur C. Brooks, America is locked in a culture war in which either America will continue to be an exceptional nation organized around the principles of free enterprise, limited government, a reliance on entrepreneurship and rewards determined by market forces, or America will move toward European-style statism grounded in expanding bureaucracies, a managed economy and large-scale income redistribution. Brooks states that while some have tried to dismiss the "tea party" demonstrations and the town hall protests as the work of extremists, ignorant backwoodsmen or agents of the health-care industry, this movement reveals much about the culture war that is underway, and it is not at all clear which side will prevail."

Untermyer: Is not commercial credit based primarily upon money or property?

Morgan: No, sir. The first thing is character.

Untermyer: Before money or property?

Morgan: Before money or anything else. Money cannot buy it ... a man I do not trust could not get money from me on all the bonds in Christendom

J.P. Morgan testifying before the Pujo Committee

Monday 12 July 2010

Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.

Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount. How convenient...

I commented previously about the first quarter being the perfect game, the second quarter will be seriously different for Banks profits this time around.

A fast and furious tightening of credit spreads allowed Banks to publish record profits for 2009.

With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard times to reap in similar profits they made in Q1.

As per below's Bloomberg article, Banks are now using the same accounting trick they used previously to boost their profits in a difficult trading environment.

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

The capital buffer is shrinking...and the DVA (Debt Valuation Adjustments) are returning with a vengeance.

DVA Gains:

"Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Citigroup Analyst Keith Horowitz’s estimates."

Accounting ‘Abomination’

"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

David Hendler, Senior Analyst from CreditSights Inc. sums it up nicely in the Bloomberg article quoted above:

When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,”

Hence the recourse to DVA accounting practices.

When the game is not going your way, just change the rules...

Another nice move from FASB in 2007.

FAS 157 was reviewed in 2009 to allow more flexibility and issued in September 2006.

"On March 9, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)". Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis. On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.

On April 9, 2009, FASB issued the official update to FAS 157 that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009. It was anticipated that these changes could significantly boost banks' statements of earnings and allow them to defer reporting losses. The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

In January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of inflated bankers' bonuses. This is because it produces a self-reinforcing cycle during a rising market that feeds into banks' profit estimates."

Basically, FAS 157 enabled banks to boost earnings in good times and pay themselves record bonuses and suffer catastrophic losses during the credit crisis, generating excessive margin calls on derivatives trades.
At the same time FAS 159 for DVA, enables banks to increase earnings in bad times.

The issue was anyway excessive leverage in conjunction with inappropriate accounting principle FAS 157, which led to seismic losses in US banks. Whereas in Canada bank leverage was capped to around 20 times. The capital buffer was therefore more significant. RBC still boast a AAA Rating.

The shadow inventory of REOs (Real Estate Owned, following rises in foreclosures) is putting additional strains on banks earnings. Inevitable adjustments to interest rates would as well put additional pressure on Banks Balance sheets. The current steep yield environment is helping tremendously banks in shoring up capital, provided their play is short duration (2 to 4 years). The risk is higher for Banks if they start buying longer duration trades on MBS (Mortgage Backed Securities). MBS are more abundant than US treasuries or short term liquid investments and are also offering higher yields as well. The temptation is there...and the risks are real if there is a sudden rise in interest rates.
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