Wednesday, May 27, 2009

The Interest Rate Problem of the Federal Reserve

The “Bond Fears” in today’s Financial Times could be the epilogue to my 3-part series on the international monetary relations. (I do not provide a link because you need to subscribe to FT to read this particular article.) After pointing out that the yield on 10-year treasuries had gone up 26 basis points in two day, the article asks:
What’s going on? The fall in equities is scary but comprehensible. Not so with the bond sell-off … Fixed-income investors are now genuinely bewildered. The long-term trend, the latest inflation data, not to mention the experience in Japan, all point to lower yields. Buying by the Fed is another reason to favour bonds. But this latest sell-off, taken alongside the weakness of the dollar, suggests something far more terrifying is causing sleepless nights.
What is going on is this: The Fed is trying to resolve an economic crisis by means of technical maneuvers. Whether this is due to an “invincible faith in oneself”, a profound ignorance of economic relations or the absence of any other policy option, matters not. The result is the same. The bond yields are going up (and bond prices down) when the opposite is supposed to happen. That is how you know a force more powerful than the Fed’s is at work.

I will return with more on this.

Sunday, May 24, 2009

An Analysis of International Monetary Relations – Part 3: Where We Are Going

Hegel famously said that history repeats itself. Marx equally famously said that Hegel should have added: first time as a tragedy, the second time as a farce. Marx should have been more precise. History does not repeat itself only twice. It constantly “repeats” itself, each time at a qualitatively higher plane, corresponding to a progressively more developed stage of the society’s productive forces. Tragedy and farce are always present, farce being a tragedy brought on by the ignorance of self-assured men. That is why Hegel characterized the “invincible faith in oneself” as the chief quality of a comic character. As the societies advance, farce becomes more pronounced because the contradictions become more intensified.


This is an important point which I will take up in detail in Vol. 5 of Speculative Capital. Here, let me try to explain it with an example.

Take Holbein’s oil painting, The Ambassadors, which is a signature art work of the dawn of Capitalism.

What makes this 1533 work so contemporary is the pose and confident gaze of the two characters “at the camera”. The men stand next to the various artifacts – the “stuff”, in modern language – that represent wealth. But this is not the fixed wealth of old social orders. It is a dynamic wealth associated with international commerce – look at the globe and navigation equipment – and ultimately, the power of money. We are way past the barter trader here.

Except for the “distorted” skull in the foreground that was a common code then for the life’s transitory nature, there is no hint of irony in this painting. It is a serious work, as indicated by its title.

Now, look at the 1999 cover of Time Magazine in which Rubin, Greenspan and Summers are introduced as the saviors of the world.

This, too, is a serious picture; it could not be otherwise, portraying the three most eminent men of finance in the U.S. government on the cover of a prestigious weekly.

Yet, there is a teasing of sorts going on here. The caption – three men saving the world – is the deliberately exaggerated language of advertisers, like saying that BMW is the ultimate driving machine. It is an ad blurb that a modern reader is expected to recognize. The picture’s background, unlike in The Ambassadors, is austere. In fact, there is no background to speak of. The close-up shot merely makes Greenspan look like a three-headed hydra, albeit a smiling and friendly one. Heads contain brains, intelligence and ideas. All three men are closely associated with the globalization. And all three are at the pinnacle of power and prestige. That is what the picture is selling: the idea of the finance capital as the all-powerful savior of the world.

Of course, the reader does not quite buy that suggestion, in the same way that he does not believe a BMW is the ultimate driving machine even when he owns one. Neither do our “saviors”. Yet, the idea is pushed in earnest. That is a setup for farce. Rubin and Greenspan signal it by their grin; the celebrated genius Summers, by his discomfort and embarrassment at taking part in it.


The instigators a social farce are not harmless clowns. Charlie Chaplin understood this important point. His clowns make you laugh but he never allows you to forget that the buffoon who is amusing you is perfectly capable of doing serious harm. The word farce has a social connotation.


As a result of what has transpired in economic and financial relations between the countries in the past 30 odd years, Chinese are holding just under $2 trillion of USD-denominated assets, with half of that invested in the U.S. treasuries and agencies. These are the liabilities of the U.S. government, and the ability of the U.S. to extinguish them in such a way that Chinese and other creditors would not suffer is now the central issue of international finance.

On the surface, this circumstance appears similar to the late 1960s, when the European and Japanese central banks with large dollar reserves were expressing concern about the dollar’s convertibility to gold.

But setting aside the changed landscape of global politics and economics, there is a critical difference between now and then. The Bretton Woods crisis was about the ability of the U.S. to convert dollars to gold. The current issue is about the ability of the U.S. to “handle” its unsecured debt. Gold is out of the picture.


This is probably the closest I will come in this blog to giving trading and investment advice. But if you are concerned about the rise of inflation and would like to put your money into something “tangible”, stay away from gold. Gold is on its way to shedding its status as the universal money, as the universal depository of value. In coming years, if the price of gold increases, it will do so in its capacity as a metal, the way the price of iron or aluminum might increase.

Lenin said that after the world-wide establishment of Communism, gold would be used for furnishing public lavatories. He had this demonetization of gold in mind, a spectacularly theoretical notion that speculative capital brought to the realm of possible in a little over 30 years. This point is important. Gold is demonetized not because of the decision of this or that authority but as a result of a historical process that gave rise to speculative capital and “globalization”, and, at the same time, set the financial system on a path towards a systemic collapse.

The financial system could somehow be “repaired”, but there is no going back to gold. History does not repeat itself, in the sense of returning to where it was previously.


To prevent a complete meltdown, the U.S. government has pledged about $13 trillion in guarantees and actual payments to various entities, mostly financial institutions.

Then, there are the other, more persistent financial holes the U.S. government also has to plug. The Treasury must finance a $1.8 trillion budget deficit and a $1 trillion trade deficit through issuing bonds.

The tremendous demand for borrowing pushes the interest rates higher. To bring them lower, the Federal Reserve does “quantitative easing”, i.e., it buys the Treasuries. To pay for the purchase, the Fed creates money from thin air through an accounting entry; poof, and there is a trillion dollars.

No currency could withstand such persistent debasing and not lose its value. Hence, the Chinese's lingering unease about the weakness of the dollar.

But it is not the Chinese only. The recent G20 Conference in London this past March was the first economic/financial conference in the past century in which the U.S. not only did not set the agenda and dominate, but it was visibly relegated to the periphery. That more focus was placed on Michelle Obama’s fashion sense than her husband’s conference agenda said all there was to be said about the shape of the future to come.


Macro developments in economics and finance have a long horizon. They certainly do not happen overnight. The eddies of international finance, furthermore, produce transient effects; a weak dollar could temporarily appreciate against one, two or even all currencies. But the writing is on the wall: the dollar is on its way towards a structural depreciation against all major currencies, including yen. From there, the loss of its status as the main reserve currency will necessarily follow.

If this were the only bad news, it would be good news. But this is not your father’s monetary crisis.


The dollar became the world's money through its linkage to gold, which historically had that role. What made the linkage possible was the industrial might of the U.S. Without it, the U.S. could not have been in possession of the sufficient amount of gold – it would not have been in a position, period – to orchestrate the Bretton Woods system. Financial maneuvering and one-upmanship, even of the aggressive kind that Harry Dexter While pulled off at the Bretton Woods Conference, could not by themselves create a new world monetary order.

The linkage to gold provided a built-in frame of reference for the value of the dollar and its quantity in circulation; if the amount of dollars in circulation relative to the supply of gold increased, the dollar would be “weak”.

The breakdown of the Bretton Woods system did away with that frame of reference and, in doing so, set the stage for the expansion and subsequent ascent of finance capital.

The “ascent” meant that finance capital could claim a historically larger share of the country's newly produced value. That could only come at the expense of the industrial capital. So the ascent of finance capital was the beginning of the systematic weakening of industrial capital, that is to say, the systematic attack on the industrial base of the U.S. The destruction we are seeing in all spheres of economic activity is the result of this conceptual and yet very real conflict. The “system” in systemic collapse goes far beyond financial markets and institutions.


A complete analysis of the the relation between finance and industrial capital must await Vol. 4 of Speculative Capital. (That would be the “relation between Wall Street and ‘real economy’”, as it is commonly put because those who put it have no other way of putting it.) For now, an example should suffice.

Take any industrial corporation with a “finance arm”. Take, for example, GM and GM Acceptance Corporation, as the U.S. car companies have been on the news for the past 20 or so years.

The raison d'etre of a car company's finance arm in providing financing to car buyers is so they would not wait weeks for bank financing. Gradually, as this means towards selling cars becomes profitable, it become an end in itself, with the inevitable mission creep that follows. The following story captures this fateful reorientation.
The world’s biggest car company said Tuesday that it earned record second quarter earnings of $1.8 billion US on revenue of $48.7 billion ... General Motors Acceptance Corp., (GMAC), the car maker's financial services arm, contributed $395 million to its income.

The GMAC financial arm pulled in more profit in the second quarter, despite higher interest rates than in 1999 ... GMAC provides a variety of lending and insurance products. It recently became involved in commercial finance, full-service leasing and international mortgages.

We learn that: i) despite a difficult economic environment, the contribution of GMAC to GM's bottom line increased; and ii) GMAC is expanding to new areas, including mortgages.

Here is the result:
GMAC LLC, which provides loans to buyers of General Motors Corp vehicles, said its first-quarter loss grew 15 percent, reflecting an increase in soured mortgage and auto loans as the economy weakens.

But by far, the most pernicious impact of GMAC was in influencing the production cycle of the parent company. GMAC and other sister financing arms created the concept of “leasing” which implicitly assumed that the GM car buyers would get a new car every three years. The production cycle and car design was adjusted around that assumption. This is the ultimate example of production dog wagging the finance arm, with the results plain for everyone to see.

Car companies need not perennially be on verge of bankruptcy. Car companies could be, and the vast majority of them are, profitable.


The most pernicious damage of finance capital is the destruction of the “business model”. It initially creates a binge of easy profits and, in doing so, changes the organization of the enterprise in line with the “new”, finance-oriented model . Over time, the new model proves the instrument of undoing of the enterprise.


The U.S. industrial base remains formidable by any measure. But so is the scale of the destruction of the value. It is astounding how little effect almost $13 trillion in commitments and guarantees have had on the markets.

Meanwhile, the farce continues with clowns calling for the creation of a New American Century, as if bombast could be a substitute for economic might. In this way, they provide the surest evidence to date that the 21st Century is the American Century no more.

Wednesday, May 6, 2009

The Fault, Dear Brutus ...

Today, the Center for Public Integrity, a journalistic watchdog, published the results of its investigation into the causes of the subprime mortgage meltdown which precipitated the larger meltdown. The Financial Times headline summed up the gist of the report: Few escape blame over subprime explosion. The paper went on to say, quoting the report, that “almost every US power centre had a hand in lighting the fuse to the global meltdown”, and that:
Most of the top 25 originators, most of which are now bankrupt, were either owned or heavily financed by the nation’s largest banks, including Citigroup, Goldman Sachs, Wells Fargo, JPMorgan and Bank of America. Together, they originated $1,000bn in subprime mortgages in 2005-07, almost three quarters of the total.
These supposedly hard hitting reports are a monumental waste of time. If everyone is guilty, then no one is guilty. We learn nothing from them except a back-handed confirmation of our prejudice about the human fallibility. We are being preached an antisocial sermon.

Here is what I wrote in the opening paragraph of the 10-part Credit Woes series early in 2008 that began this blog.
The events leading to this seizure have been covered in detail from many perspectives but always within the same prescribed framework: the crisis as the culmination of a series of unfortunate events set in motion by (choose your emphasis) greedy traders, irresponsible lenders, foolish borrowers, sleeping-at-the-switch rating agencies and feeble regulators.

The focus on human element makes for good storytelling and has an evangelically uplifting bend that is appealing: If only the bad guys were to be replaced with good guys – something definitely in the realm of possible – the wrongs will be set right. The fault, dear Brutus, is not in our stars, but in ourselves!

Such takes on the crisis are not inaccurate; they are irrelevant. The subject matter of finance is not people; it is capital in circulation.
Go back and read the full series again. You will notice that against a background that shattered the most cherished beliefs, it has aged well. In fact, it has even improved with time, as all its “forward looking” statements have come to pass. That is the power of a correct theory, which is derived from the power of the truth. It is that relation, that correspondence, that stands the test of time.

Tuesday, May 5, 2009

A Humble Proposal For Reducing Speculation

“Of our time” description, when used for a poet, a writer or a philosopher, could have two distinct and opposite meanings. One is that of a fool who struts and frets his hour upon the stage but is nevertheless useful, the way an inanimate archeological object is useful, because in deciphering what he uncomprehendingly recorded we could learn about his time. The other is that of a knowing, perceptive observer who is conscious of the goings on around him and can therefore add to our knowledge with his observations and insights.

T.S. Eliot is a poet of our time strictly in the latter sense. He has an eye for the social ills as they affect individuals. Of particular interest to him is a large class of hollow men. Hollow man, as competently elaborated by Craig Raine in his study of T.S. Eliot, is “a physically damaged, confined soul, corroded by its own caution, a life disfigured and distorted, rusty with reluctance”.

This phenomenon, which is present at every age, especially stands out in modern times because it stands in contrast to, and in mockery of, the slogans of free men. The commonness and its uncomfortable implications are politely hidden in a neutral word: pragmatist. The pragmatist keeps a respectful distance from established prejudices and relations, follows the consensus and never, ever rocks the boat, no matter how urgently the boat might need a shakeup.

I thought of all this as I read last Thursday that the Federal Reserve was considering imposing a 3 percent penalty on failed treasury trades.

A fail trade is a trade that a short-seller fails to deliver. I wrote about short selling in detail last year in relation with the unraveling of money markets:
The sec lending market is driven by short selling, or shorting, which is selling something you do not have. Outside the financial markets, the practice amounts to fraud; if you sell a house, or a car, or a farm you do not have, you would probably go to jail. In the financial markets, the practice is legal and very common. With the ownership requirement eliminated, the buy-sell sequence could be reversed; instead of buying first and selling later, you could sell first and buy later.
In all events, the seller must deliver. Confronting him is a buyer who demands the security he just purchased. Since he himself does not have the security, the short-seller must borrow it or somehow find it in the market. When he fails to do so, in consequence of which he could not deliver the security to the buyer, we have a fail-to-deliver. It is this failure on which the Fed is imposing a 3% penalty. Here is part of the original story:
A Fed-endorsed industry recommendation will require traders to pay a three-percentage-point penalty on uncompleted trades, known as fails, starting tomorrow ... While the new recommendations are meant to curb disruptions caused when traders fail to meet their obligations, some strategists are concerned it may do more harm than good in the $7 trillion-a-day repurchase market, where dealers finance their holdings. A reduction in trading would be a setback for the Fed as it seeks to lower borrowing costs by pumping cash into the banking system and purchasing as much as $1.75 trillion in Treasuries and mortgage securities.
Let us set aside all distracting technical points and focus only on the core issue: short-selling U.S. treasury securities.

Buying treasuries is lending money to the U.S. government; you get an interest bearing security from the government, the government gets your cash. Selling treasuries you own is calling back your loan. You get your money back and a new lender to the government (who bought you treasuries) replaces you and your capital.

Selling treasuries you do not have is borrowing money as U.S. government. Only the U.S. government can borrow money as the U.S. government, in the same way that only the U.S government can print money. I discussed this point in Vol. 3 of Speculative Capital:
Yet another critical point went unnoticed: how could we short a riskless bond? Shorting a bond means borrowing money. In the yin yang of borrowing and lending, risk is defined with reference to lender only. As borrowers, we face no risk; we could take the lender’s money and run. Risklessness of the US Treasuries, likewise, refers to risklessness of these securities to their buyer – those who lend to the US government. The securities are riskless because the US government would not default. It then follows that only the US government can short a riskless bond, in the same way that only the US government can print money; we, as individuals cannot. It is astounding how often the difference between buying and selling, lending and borrowing escapes the attention of the finance scholars.

The closest equivalent to shorting treasuries is counterfeiting money. Failing to deliver short is selling counterfeit money that you do not even have! Yet everyone in the market treats it as a birthright.

Imposing 3% penalty on a small part of the market – the fails – is a timid and irresolute act. It will do nothing by way of improving markets no matter how you measure it.

The correct policy action would be to warn the “market participants” that a complete ban on short selling treasuries will be implemented in a few months and then on the designated day, pull the trigger. You will be surprised how quickly and extensively the speculative element will be flushed out of the markets.

Looking around, I expect this policy to be implemented in the morning after the Judgment Day.