Sunday, April 24, 2011

Adjustment scenarios for JGBs

Reuters reports Japan GPIF to withdraw $78 bln from assets.
The GPIF is likely to raise cash by selling JGBs and other assets in its portfolio as pension contributions and tax income continue to fall short of pension payouts which are growing as Japan's population ages, the newspaper said.
The largest buyer of JGBs, is not just reducing purchases, or failing to roll over maturing bonds, but will be a net seller this year. That is a watershed moment. The Japanese government, with astronomical debt-to-GDP over 200% may be a harbinger of things to come for western governments with heavy debt loads. We've seen bond market failures already for Greece, Ireland, and Portugal at much lower debt levels.

Japan has been given a great deal of slack because it has large net exports, and the unusual fact that it's government bonds are 90% funded internally through pension funds and private purchases. It appears the time is fast approaching when private purchases are no longer sufficient to fund bond issuance. I've been trying to think through possible ways Japan and/or market forces will adjust to this change. How will JGBs be funded in a future where private funding slows down?

Foreign purchases might surge

The shortfall could be met with increased foreign purchases of JGBs, from sovereign wealth funds, hedge funds, or central banks. At current interest rates, the lowest in the western world, it is hard to imagine any large buyer would think Japanese bonds were a good investment. It is possible that foreign central banks might agree to support Japan and purchase some with the goal of averting a global crisis. The Fed in particular has been accommodating of most any request for dollars.

Japanese bond issuance slows due to voluntary austerity

The government of Japan may decide to dramatically reduce spending and reduce deficits. Where spending cuts are made is likely to be a heated political battle, much as in the US.

The BoJ monetizes JGBs

Following a standard operating practice since the 1990s, the BoJ may increase their purchase of bonds in another round of quantitative easing. While events may include elements of each policy and market response to the JGB problem, I view BoJ QE as the most likely and to make up the bulk of any shortfall from private purchases.

The danger of unlimited QE is that the amount monetized becomes absurd at some point. Whether that is 250% debt to GDP, 400%, or when the total tax revenues no longer cover the interest due on outstanding bonds. Something will be a trigger point where either the Japanese people or Japan's trading partners lose faith in the yen. An extreme currency crisis can be only be met with extreme policy choices.

Extreme policy choices

Once a currency crisis has begun, Japan can choose to default on outstanding debt due and preserve some value in the currency, or print money to cover every bad debt leading to hyperinflation. Both choices are painful for the citizens and country and may lead to unknown political consequences. Despite all the advantages accrued to Japan, it may be the first major advanced economy to go over the Keynesian cliff.

Friday, April 22, 2011

Subjective Invective v.4

NPR Planet Money on Gold

A recent story on NPR Planet Money, Why We Left the Gold Standard, is an amazing mixture of misunderstanding and tangential anecdotes without ever managing to answer the question in the title.
In the early part of the 20th century, all the world's key economies were on the gold standard.
But in 1931, the system began to unravel in the most powerful country in the world: England. When the Great Depression hit, the people in England panicked, and started trading in their paper money for gold. It got to the point where the Bank of England was in danger of running out of gold.
The article never tries to explain why the people wanted gold instead of paper, or why the Bank of England was in danger of running out of gold. It was because the Bank of England was on a fractional reserve gold standard and they issued too much paper to be supported by the gold reserves. Banking, as it grew out of original goldsmiths issuing paper receipts for gold deposits, was a fraud from the start. The goldsmiths could issue more receipts than the gold they had on deposits and as long as not too many people redeemed their receipts at the same time, no one was the wiser. Modern bankers lend out deposits while pretending that all their deposits are available to all depositors all the time. But just like the goldsmiths, if too many depositors want to redeem their paper money receipts, the bank fraud is exposed and the bank fails.
"Because of undermined confidence on the part of the public there was a general rush by a large portion of our population to turn bank deposits into currency or gold," Roosevelt said.
When he gave this speech, Roosevelt knew the gold standard was a problem. But he wasn't sure what to do about it.
The undermined confidence grew after large numbers of banks failed (eventually about half of all banks) and people lost their deposits. There was no FDIC insurance and people, at least some people, knew that banks didn't have enough gold or reserves to pay all depositors. Fractional reserve banking is inherently unstable by design.
"Most economists now agree 90% of the reason why the U.S. got out of the Great Depression was the break with gold," Ahamed says.
Going off the gold standard gave the government new tools to steer the economy. If you're not tied to gold, you can adjust the amount of money in the economy if you need to. You can adjust interest rates.
Most economists have been wrong about most everything, from the Great Depression through the Great Recession. The break with gold happened in 1933 and Depression raged on until after World War II. There was a powerful segment in "Inside Job" showing the duplicitous nature of academic economists. Their opinions and services are for sale and they are happy to offer up some kind of defense of any policy for which they are paid, without, of course, disclosing their financial arrangement. The U.S. got out of the Great Depression only when World War II created massive demand, 400,000 Americans were killed and the productive capacity of the rest of the world was destroyed, creating even more demand.

Being able to issue unlimited unbacked credit and change interest rates to benefit your friends is indeed a powerful tool. The Federal Reserve had all those tools long before the Great Depression, with the exception that their ability to issue credit was restricted by a 40% fractional reserve limit, part of the original Federal Reserve Act.

The author does not discuss why the banks were running out of gold, why FDR confiscated gold from citizens in 1933 then devalued the paper notes he forced them to take -- against the gold he took from them -- and made it illegal to own gold, which remained in effect until 1975. The author does not talk about the fact that the U.S. only went off the gold standard domestically, but continued to redeem dollars for gold with foreign governments until 1971 when Nixon broke the final ties between the dollar and gold. Gold was used to settle international trade balances at the IMF until 1978. The author seems to imply that the US went off the gold standard because it gave the government new tools for central planning of the economy. In fact the only new tool it gave the government was the ability to issue unlimited unbacked credit. The government could devalue people's savings at will. The author seems to have no understanding of monetary history.

Saturday, April 16, 2011

U.S. Senate Report on the Financial Crisis

On April 13, 2011, the PERMANENT SUBCOMMITTEE ON INVESTIGATIONS in the US Senate released a report called WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse (pdf).

It is a massive report with plenty of damning evidence, implicating Goldman Sachs and Duetche Bank among others. The net of blame is cast wide, with good reason, citing failures of OTS regulators and the rating agencies.

I haven't had time to dig into too many details, but I read the overview and the 19 recommendations for reform included in the summary. The recommendations are broken into 4 areas, High Risk Lending, Regulatory Failures, Inflated Credit Ratings, and Investment Bank Abuses.

My initial reaction is that all of the recommendations are good and would improve the financial system, but none address one of the root causes identified in the collapse. No provision is made to dismantle Too Big to Fail institutions. There is a suggestion to make banks hold higher reserves against high risk investments, but nothing to address size and scope issues of TBTF.

A second glaring omission, I believe, is a better way to incentivize rating agencies. Instead of the issuer paying the agency, I think a much better model is for investors to pay the agency for an honest opinion. Kind of a consumer reports for financial investments. The Senate report suggests that the SEC rate the rating agencies on their accuracy, but this seems like a poorly thought out half-measure to me.

If any of the suggested reforms are enacted, it will be an improvement, but I believe it will leave the system vulnerable to a similar kind of collapse in the not too distant future.

Monday, April 11, 2011

Twilight's last metal gleaming

Starting in 1965, the US began to actively debase metal coins in circulation by removing silver from the dime, quarter, and half dollar. The half dollar went from 90% silver to 40% silver, then 0% silver by 1971. In 1983, the penny went from 95% copper to 97.5% zinc and 2.5% copper. Both copper and silver became worth much more than the face value of the coins. Monetary debasement has been common throughout history as inflation eats into the value of the "official money". Consequently, governments require greater seigniorage and taxes to keep overextended empires going.

Today, there is one US metal coin remaining with a metal value greater than the face value: the lowly nickel. The nickel composition is 75% copper and 25% nickel. According to, it has a metal value of roughly 7.1 cents or about 42% above face value.

There was a brief period during World War II when the composition was changed to 56% copper, 35% silver and 9% manganese to preserve the nickel for war needs. It was a rare period when the nickel had no nickel in it. It went back to the copper-nickel alloy after the war.

Don't take any wooden zinc nickels

Straight from Wikipedia...
Gresham's law is an economic principle "which states that when government compulsorily overvalues one money and undervalues another, the undervalued money will leave the country or disappear into hoards, while the overvalued money will flood into circulation."[1] It is commonly stated as: "Bad money drives out good", but is more accurately stated: "Bad money drives out good if their exchange rate is set by law."

With the nickel undervalued and other coins and paper overvalued by fiat, it is only a matter of time before either nickels start disappearing from circulation as they are hoarded, or the US Mint decides that paying more than double the face value for the current nickel alloy doesn't make sense and will change it something like the new penny, 97.5% zinc. That action may also cause the copper-nickel version to be hoarded.

Trying to stay only one step ahead of the crowd, I have started collecting nickels. The risk is that I will miss out on 0.1% interest in my money market fund, but there is no acquisition cost or deflation risk. I started with a humble request for 10 nickel rolls from my credit union. Sadly, they only had 7 rolls in the entire brach. I was able to double that from the loose change jars of two friends. I've added copper and nickel charts to the blog.

I am prepared to wait 10-15 years on my nickel speculation. The 1964 silver coins didn't become a big win until 1979 or 1980. I'd rather be wrong about the active and earnest debasement of the dollar, and will happily return my nickels to the bank when I am convinced it is safe to do so.

Tuesday, April 5, 2011

Real Per Capita Income and Debt


This chart shows the last 10 years of national income and national debt per capita, adjusted to 2010 dollars. Per capita income rose slightly, while per capita debt rose very sharply, on a trajectory to double within the next few years.

Despite the comparison of a stock vs. a flow, I find it ominous that the debt crossed the income line around the beginning of 2010. The debt shown is only federal debt. It does not include private debt, state or local government debt. The chart also doesn't address the distribution of that income which is becoming more concentrated in the top quintile.

Saturday, April 2, 2011

Subjective Invective v.3

source: OMB Table 1.1—Summary of Receipts, Outlays, and Surpluses or Deficits (-): 1789–2016

The federal budget debate and potential shut down have been in the news lately. I started reading the overview of the budget from the President's Office of Management and Budget and found the expected double talk and misdirection.

The Budget includes more than $1 trillion in deficit reduction – two-thirds of it from cuts -- and puts the nation on a path toward fiscal sustainability

If you read a little further, you find out that the the $1 trillion deficit reduction is projected over a 10 year period. The President is claiming that a 6.6% reduction in the current year $1.5 trillion deficit is sustainable. It's not. The OMB makes optimistic projections for the next 5 years of job and wage growth and assumes no new recession will appear. Even in that case, the deficit never gets smaller than $500 billion.

Five-year non-security discretionary spending freeze will reduce the deficit by over $400 billion over the next decade and bring this spending to the lowest level since President Eisenhower sat in the Oval Office.

Non-security discretionary spending is less than 15% of the budget, and the part that is not growing. What is growing automatically every year are Social Security, Medicare, and Medicaid, accounting for over half of the budget. The other large outlay, the MIC, is also deemed untouchable. To mention Eisenhower in the same sentence as making defense spending off limits is the height of hypocrisy, like putting Jackson on the $20 Federal Reserve Note.

Pays for a three-year patch to prevent an increase in taxes on middle-class families through the Alternative Minimum Tax (AMT) by limiting the rate at which high-income earners can itemize tax deductions.

Why does Congress insist on patching the AMT every year? Here is my permanent fix: index the AMT amounts to the CPI and forget about it. Inflation is why the AMT is hitting so much of the middle class now. Full disclosure: I had to pay about $800 extra in AMT this year, the first year I ever had to pay it. The only reason I can imagine why they don't want a permanent fix is because they plan to stop patching it at some point when it applies to everyone and just becomes the base line for higher taxes.

The whole thing is further evidence that the US is politically incapable of fixing the budget and deficit problems that face the country.