Jeffrey Snider is someone to watch. Can't say I agree with
everything he says ;
and someone who makes the system, if not transparently
clear ( maybe no-one
on Earth can do that ), at least clearer than before.
relevant now is his wager that Europe is entering a
recession now and that
the USA will shortly follow, probably in the next 2 or 3
months.
Could be his prediction won't pan out. I would sympathize.
Economics is complex
and there are so many dependent variables --and just about
no independent variables--
that forecasting outcomes is best compared to the
likelihood of herding cats successfully.
But he has given it his best shot and in the process
exposes us to just what kind of mess
the economy actually is in.
Here is one of his statements that I happen to agree with
at the 100% level :
These have been my sentiments for at least 2-1/2 years. And
these are the sentiments
of 99% of the 99%, viz. OWS and its supporters.
But do not fear, there is plenty in the article that is
pro-market and pro-investor and,
quite simply, nothing that is orthodox by anyone's
standards. I like that !
As before, I have added a large number of emphases in BF.
If you wish to read
the article in its unredacted format, simply click "select
all" and then click the BF button
enough times to return the piece to its original condition.
But do read it if you have an interest, it is educational
in the best sense of the word.
The concept of monetary elasticity is quite simple in
theory, something we are now well accustomed to in the
current age of consistent crisis. During times of distress,
investors within the banking system's cumulative liability
structure increase their preference for holding cash over
the continued holding of those bank liabilities (whether
that is demand deposits, hybrid preferred securities,
commercial paper or senior bonds). Since the banking system
operates on a fractional basis, the demand for cash far
outpaces a bank's ability to pay all of those redemption
requests - a liquidity event.
Monetary elasticity "fixes" this problem through central
bank injections of "liquidity". If the central bank pushes
enough money into the banking system to meet those
redemption requests, then the panic should largely subside
as liability holders are further assured that liquidity
remains available on reasonably easy terms. But money
elasticity, at least in its traditional format, presupposes
that "access" to money is the overriding factor in this
shift in liability-holder preferences.
In the 21st century, access to currency has never seriously
been threatened. Instead, the shifting preference of
liability-holders has been based solely on avoidance of
capital losses. I have maintained that deflation (the
real, devastating currency disease, not disinflation in
prices due to weak demand) in the real economy was
never really possible because access was never seriously
threatened. Instead, banks were threatened because
bond-holders, especially those holding very short-term
liabilities, refused to continuously rollover various
obligations within the cumulative banking system structure.
That refusal was, again, not about access to cash, it was
about avoiding losses that would inevitably follow from
banks whose cumulative assets were worth less (and in some
cases far less) than liabilities, i.e., solvency.
From the central bank perspective, at least their publicly
avowed perspective, the central issue of solvency was due to
market-based declines in the prices of relatively illiquid
assets. To wit: on July 28, 2008, Merrill Lynch (then a
standalone company) "sold" a super senior tranche of a
mortgage-ABS CDO. The notional value of the tranche was
$30.1 billion. In June 2008, the tranche was valued at $11.1
billion, a huge $19 billion writedown. The reported sales
price was $6.7 billion, another 50% wipeout from the June
level.
Putting those numbers into perspective, since this was the
super senior piece with some amount of credit enhancements
above it in the capital structure of the CDO, would have
meant a 100% default rate with an epically low recovery rate
of about 36% (or an 80% default rate with about a 20%
recovery rate). None of those numbers were anywhere near the
true conditions of the mortgage market, even the subprime
mortgage market in its worst state. In other words, the
market price of the tranche during this period was nonsense,
brought about by supply and demand factors (illiquidity and
dysfunction) in credit default swap trading.
Without getting too far into the weeds of the intricacies
of correlation trading, by March 2008 tranches of various
pieces of various vintages of various structures were quoted
in correlations above 100% - a mathematical position that is
meaningless. The bottom line here was that, for reasons that
had nothing to do with the fundamental properties of the
mortgage marketplace, overvalued as it was, pricing in these
"toxic" assets was nothing but noise, inappropriate under
any circumstance. That gave credence to the March 2009 move
to do away with mark-to-market, and further support to QE
1.0 where the Fed would buy these mortgage assets at some
value that was probably far closer to par or nominal than
many people would feel comfortable with.
This brings up the uncomfortable debate about what prices
are the most "appropriate", especially within the framework
of a full-on crisis. Should these market prices, meaningless
in terms of fundamental valuations, be used when deciding
which bank is solvent at any given time? Obviously, given
the way policies were structured, central banks have come
down emphatically on the side of manipulation - basically denying
that the market has any rational sense in setting the
price of these types of assets and further
determining the general solvency of bank institutions, both
idiosyncratically and, more importantly, cumulatively. In
the case of those "toxic" mortgage securities, this, again,
seems to be the appropriate course, at least on the surface.
Where money elasticity comes into play here is the
liquidity pressure that this tug-of-war in pricing
generates. Banks may believe that assets are money
good and that market-based prices are absolutely
inappropriate benchmarks for solvency, but individual
investors can and do see things differently (that is what
makes a market) and react for different reasons. Investors
might even concur that assets, in the long-run, are "money
good", but not be able to stick around and take that
chance if there are reasonable doubts or questions
surrounding those assets. Holding on to
questionable assets entails real risks to those investors,
ancillary as they may be in the context of fundamental
valuations, that are not well understood by anyone other
than those unique investors. I'm talking about hedging and
its impacts on how assets, especially credit assets, are
dispersed and held throughout the "system" (indeed, that was
the primary problem with credit default swap trading, the
increased need for hedging created worse pricing in
structured finance, which created the need for more hedging,
and so on). Even in the Merrill Lynch example I cited above,
it is very likely that Merrill Lynch felt it was
getting fleeced on the sale, but could not hold onto that
particular asset any longer for reasons that had little to
do with the fundamentals or even their outlook for that
asset.
So central banks have become the firesale buyer of
last resort, supposedly taking the long view on these
assets. Since central banks have none of the pressures of
investors, and control the ability to generate liquidity
on demand, they can mediate the short-term noise and
apparent meaninglessness of market prices and the longer
run cash flow of any asset in their possession. That is
what money elasticity has become - the bridge from
insanity (from their perspective) to more docile
conditions where investors can "come to their senses".
Except that it appears, on more than one occasion, that
investors and their crazy market prices have been right.
[ ? ] Greece is the most well-known example. For
over two years, the ECB has used this new money elasticity
process to prop up the value of Greek bonds, all in the name
of avoiding a Merrill Lynch-type situation in peripheral
sovereign bonds, and the general "contagion"
that might foster. But for all the bonds the ECB purchased,
for all the price manipulation done in the name of creating
a bridge to saner days, all the ECB did was fool more banks
(ahem, MF Global, Dexia) to follow it down the rabbit hole
to further instability, and, yes, even greater insolvency.
So the paradigm of money elasticity is no longer
about access to cash in the real economy, it is used as a
measure of countering market prices, all done in the name
of the market always being wrong. However, even
in the case of subprime mortgage bonds that were pricing
insanity, the Federal Reserve, which until now looks to have
been correct in stepping in, may yet follow Greek debt into
full-blown default (especially if housing prices continue to
contract, or re-contract, not to mention the current,
still-hidden state of commercial real estate). That
brings up a very important point that does not seem to be
fully appreciated, especially in the context of continued
faith in central banks. What if, instead of building a
bridge to saner conditions, money elasticity in its
current usage is actually creating even more instability
that leads to even worse calamity?
Europe is the central case study on this point. By its very
liquidity methods, the ECB actively encourages banks,
especially banks that are already in the most trouble, to
buy more and more of "troubled" sovereign bonds. The biggest
buyers of Spanish and Italian debt during the LTRO periods
have been Spanish and Italian banks. And the more Spanish
and Italian debt these banks buy, the more depositors flee.
In the European system, that has led to dramatic and drastic
Target II imbalances, where capital (over and above
merchandise current account deficits) is received in the
"core" countries, especially Germany, and forcibly recycled
back to the periphery via National Central Banks (NCB). So
the money elasticity doctrine of the ECB forces the
Bundesbank in Germany to accept claims for cash against
Spain and Italy (and Greece before it). The more individual
depositor and bondholder money flows out of the periphery,
the more the Bundesbank is forced to "front" the periphery.
This forced liquidity injection, rather than help
"solve" the periphery's problem, creates additional and
greater tension, including and especially political
tension. Rather than isolating and breaking the
perpetuating feedback loop of crisis, this doctrine
spreads "contagion" far and wide without ever addressing
the original imbalances in the first place.
Again, Greece is useful as an example here. The ECB
ostensibly bought two years time for Greece to "clean up its
act", reign in deficit spending and get its current accounts
under control, but during the whole of those two purchased
years every single measurable parameter worsened, and
worsened significantly. For its part, the Greek government's
adherence to "austerity" and ability to meet specifications
were overstated at every interval, missing key targets
regularly, as if bailouts were never really serious (we know
conclusively today that they were not). Even now, after
actually defaulting, the country continues to miss key
targets that were set just a few months ago as conditions
for the latest bailout (a bailout in this context is just
the mechanism for money elasticity, especially since most,
if not all, of the actual money ends up in the hands of
banks).
Furthermore, perhaps far more importantly, investors were
correct to flee Greek debt, while the ECB was fully wrong in
supporting its price. In terms of time, the past two years
bought the Greek government enough liquidity support to run
up an additional EUR43 billion in fresh debt (CY 2010 +
2011), that was ultimately flushed down the hole in the
default, nearly taking the entire system with it on December
8, 2011, before that default was finally "decided". As it is
now, with Spain and Italy now at the forefront without a
Greek distraction, markets are following the exact same
pattern as 2011
(http://www.realclearmarkets.com/articles/2012/02/10/economics_the_science_of_hubristic_hope_99510.html).
The feedback loop of investor fear has not been
broken by all this liquidity because it has never been
liquidity that has been feared. The issue has always been
one of solvency, as in who gets to bear the brunt of
losses generated by market prices incorrectly over-valuing
assets and cash flow during one of the most artificial
growth periods in history.
Under the current rules of the banking system, liquidity is
not even a significant factor in credit creation - vault
cash is an anachronistic notion that has no bearing on a
21st century bank. Therefore, money
elasticity as it was understood and designed in 1912 has
no reference in 2012. Since equity capital is the
bank parameter that drives credit, including prices, that
over-valuation leftover from the housing bubble period
diminishes equity capital directly, and thereby liquidity
conditions derivatively. The more the system has to take
losses on credit assets, the more the system has to actively
deleverage itself, either through direct asset sales or
raising equity capital.
In 2008, losses on super senior tranches accounted for 42%
of worldwide writedowns of credit assets according to
creditflux.com ($218 billion worldwide, $145 billion in
North America alone). Since credit is pyramided on
top of equity capital reserves, not cash reserves, that
$218 billion taken out of equity capital (losses on the
income statement ultimately reduce retained earnings on
the balance sheet, the largest component of Tier 1
capital) meant a multi-trillion dollar hole in the global
banking system's ability to hold any and all assets.
That is why central banks and governments were "forced" to
recapitalize the banking system (including the final version
of TARP in the U.S.) as part of each bailout attempt, funded
by each central bank's money elasticity doctrine.
Would we have avoided the panic of 2008 had money
elasticity been fervently applied prior to Lehman Brothers
failure? Not likely, since only 42% of the losses were what
I would consider due to irregularities in the credit default
swap marketplace. That left (leaves) $300 billion in losses
that were all too appropriate. And that is the largest
problem. Investors know that there are losses to be taken,
but central banks have decided to use money elasticity on
each and every asset class or "systemically important"
obligor. Again, as in the case of Greece, investors were
correct. In the case of "toxic" mortgage assets, investors
were mostly correct (perhaps 58% correct). Money
elasticity cannot work where everyone is saved, with no
regard to how irresponsible they may have been. In that
case the irresponsible are simply sheltered enough to
continue to be irresponsible, an anathema to a functioning
marketplace.
Instead of trying to save the whole system,
preserving it as it was before 2007, central banks should
have been focused on helping the system take the painful
medication of market discipline. Greece should
have been put into default in 2010 (at the latest) rather
than deny that a default was even a remote possibility. It
would have been a serious blow to markets, but better then
than now after all the new debt that has been added.
The modern version of money elasticity allows
imbalances to grow far greater to the point they become
systemically dangerous - market discipline is the pressure
release to those imbalances. The largest banks in
the US are now even larger today than in 2008 because there
were none but a few minor failures "allowed" (what if Bear
Stearns was unwound rather than shepherded into JP Morgan,
or if Merrill Lynch failed instead of being absorbed by Bank
of America?). Lehman Brothers failed and it kicked off a
panic, but had others been allowed to follow we might not
today, nearly four years later, be still looking for the
next Lehman Brothers.[ ? ]
Market discipline, while painful and certainly
disruptive, actually solves imbalances. The 2008 panic was
likely fully unavoidable, and that is tragic that these
same imbalances were ever allowed to grow so large, but
there is no reason we have to have a rerun every few years
along largely the same lines. Taking losses and
having deflation in the financial economy would not have
been the end of the world as we know it. Central
banks can proclaim that banks and the economy are one and
the same, but that does not make it true. Again,
there was no real danger of deflation in the real economy as
currency, as in the usage of money to transact, was never in
short supply. What has been in short supply, and
remains in short supply, are sustainable streams of real
income due to productive activities - the kinds of
activities that have a hard time flourishing under
continuously dysfunctional monetary regimes.
Greece's problem, any more than subprime obligors'
problems, continues to be a lack of sustainable income due
to productive activities, i.e., jobs and profitable
businesses and taxes on both. That is now universally
recognized as the problem, meaning that investors know the
full score. Propping up prices, while maintaining
the illusion of solvency, does not really address solvency.
No one is fooled by money elasticity; even John Corzine was
not fooled. This doctrine of monetary elasticity, applied as
it is universally in the 21st century model, does not
enhance the marketplace for assets, returning it to a more
normal or "rational" footing. Reckless money
elasticity of this kind is intended to supplant the
marketplace (which is what Corzine was foolishly
betting on). In one very important respect, this is not all
that much removed from executing capital controls, the kind
of soft bureaucratic control we have come to expect in the
age of central bank indirect economic planning.
Capital controls, given this level of dysfunction,
effectively lock in these imbalances, forcing investors to
seek other, even more destructive avenues to fulfill their
negative expectations. The noose only tightens.
If central banks wanted to commit themselves truly
to avoiding real deflation and a rerun of 1930-33, they
could have pledged these trillions in new currency units
not to the banking system, but to the real economy to
ensure access to currency (instead of adhering to the
century-old, traditional notion of money elasticity
- depositors at IndyMac, for instance, had little trouble
with its deserved demise and the subsequent transition to a
new institution). Banks would have failed, prices
would have fallen and it would have been nasty (it already
was), but the system that emerged, hopefully chastened at
that point, would have created a foundation for a real
recovery. How different would our
current outlook be if investors the world over were
relatively sure that most or nearly all appropriate losses
were behind us? The real question that gets to the heart
of the matter is: what kind of a recovery would we have
experienced if the irresponsible were no longer able to be
irresponsible?
These counterfactuals are always hard because there
is no real way to be sure. What we are sure of,
and what suggests there is something rotten at the core of
this new central bank application of money elasticity, is
that current policies have most decidedly not delivered.
Europe is already in re-recession, one that will, in my
opinion, be worse than predicted by economic professionals
(admittedly a low bar). The U.S. is not that far ahead, and
by summer I have little doubt we will again, for the third
time in as many years, be joining Europe in the re-recession
chatter. Regardless of which direction we head, the one
constant is that markets will be denied, under the
faux-auspices of a hundred-year old paradigm, their proper
role of correcting imbalances because it might just work and
belie the canard that the real economy cannot survive
without the banking system as it is. Capitalism can flourish
on its own without monetarism.
