"It's the asset prices, stupid"

In a good post titled 'Why Obama is Winning' Harold James points out that political strategist James Carville's famous "it's the economy, stupid" quip from the 1992 U.S. presidential election campaign has gained a new twist:

...the lesson about the economy’s electoral salience is being subtly reformulated. It is no longer the real state of the economy, but rather the perception of asset markets, that is crucial. And the perception can be far removed from reality, which means that the more the prevailing political wisdom assigns decisive electoral importance to the economy, the greater the temptation to view monetary policy’s impact on asset prices, and not on long-term growth, as crucial.

What James is basically saying is that people feel wealthier when asset prices - stocks, bonds, real estate, etc. - go up in value. This phenomenon -- the so called 'wealth effect' -- can make those who don't read The PolyCapitalist and the other recommended sites listed on the right side of this blog feel like the real, fundamental economy is doing better than it actually is. Or so the theory goes. 

Further, positive feelings about how the economy is trending due to rising asset prices can in turn drive higher consumer consumption and business investment, which in turn can increase GDP. At least in the short (and possibly) medium run.

For how long can this wealth effect ponzi-esque scheme go on? In other words, are programs like QE3 nothing more than an macroeconomic cheap trick?

No one knows for sure because, like much of modern macroeconomic theory, we are conducting a live, empirical test of the theory. And this test has arguably been running since at least 1987 (the year Alan Greenspan became Chairman of the Fed), if not 1971 (the year Nixon severed the U.S. Dollar's anchor to the price of gold).

What this means longer-term, according to James, is further politicization of the Federal Reserve and other central banks around the world:

Republicans will blame their defeat in November on the Fed’s monetary stimulus (if not on the ineffectiveness of Mitt Romney’s blunder-filled campaign). 

Meanwhile, in Europe, many national leaders, looking at Obama and the Fed, may conclude that they would do better with more direct control over the central bank. Given the difficulty of establishing such control over the European Central Bank, the euro’s next great challenge may be growing sentiment in favor of a return to national currencies.

In other words, expect central banks to remain in the politial bullseye following the 2012 U.S. and 2013 German elections, regardless of the their outcomes.

Will major reform be applied to central banks? For example, there has been open discussion of terms limits for the Federal Reserve Chairman.

Perhaps changes like term limits, greater Fed transparency, etc. are in the cards longer-term. But I am personally skeptical that any significant reforms will be enacted at the Federal Reserve prior to the end of the U.S. dollar's global hegemony.

Buffet Badmouthing Gold is Like Geithner Talking Up U.S. Dollar

Lebron hasn't been taking financial advice from this guy, I hope? 

The fact that Warren Buffet is not a gold fan is old news.

I can't help but think about how, similar to the notion that it's never a positive sign for the currency when a finance minister feels compelled to publicly defend it, that perhaps it's a bullish signal for gold whenever Buffet feels the need to diss the yellow metal.

If you've studied Buffet you know that he chooses his words with extreme care. His financial empire is also so entrenched in the global economy that the only real risks he faces are existential ones. Such as the semi-quiet, steady run which has been taking place on the U.S. dollar since the turn of the century, when gold began its secular move upward.

Oh how it must just eat at the Oracle to know that a rock has been outperforming his precious equities for well over a decade!

Buffet was arguably the biggest single beneficiary from the 2008 government bailouts, a fact which hasn't received much airtime from Buffet-friendly business journalists (I'm talking about you, Becky). The steady devaluation of fiat currencies, like the U.S. dollar, against gold is something that this blog projects will continue. It is also something which clearly Warren would like to see slow down by badmouthing gold.

Prediction #1: U.S. Dollar Bears Will Remain On the Run in 2012

Since its March 2008 low the U.S. Dollar is up 13% against a basket of the world's most widely held currencies, including the yen, sterling, franc, loonie, krona, and of course the beleaguered euro.

How is this a problem for portfolio manager Axel Merk, the self described "Authority on Currencies"? After all, according to Merk's written after-the-fact letters he claims to have traded out of and back into the euro just in time to surf its wild gyrations.

Merk moved his fund management business to California a number of years ago, where he has been beating a steady 'demise of the U.S. dollar' drumbeat ever since. This past year Merk Funds even took to deploying amusing anti-Dollar cartoon propaganda while routinely touting the superiority of the euro over the U.S. dollar.

Continue reading the full article at Seeking Alpha here.

As the Euro Rolls Over, Why Hasn't Gold Rocketed?

In early May of this year, with the euro hovering in the $1.46-$1.48 range, I disagreed vehemently with euro bulls such as portfolio manager Axel Merk who argued that the common currency was no longer vulnerable to a sell-off (see Merk's May 11 FT article titled 'Dollar in graver danger than the euro' and my counter arguments here, here, and here). 

Merk's argument was basically that in 2010, when the euro sank to a low of $1.18, the currency served as a proxy for the sovereign debt crisis. Now, however, investors were shorting sovereign debt directly and, according to Merk, recognized that it is a lot harder for the ECB to print euros than it is for the Fed to print dollars.

For awhile, as you can see from the below chart, it appeared that Merk perhaps had made a good point. From May the euro has shown remarkable resilience; for the last six months one sovereign after another has white knuckled its way through uncertain debt auctions and ever higher interest expense. Meanwhile the ECB kept its 'bazooka' semi-holstered with purchases of sovereign debt apparently capped at €20 billion per week. While the euro did soften from mid-May onwards it was able to keep it's head above the $1.40 mark for the summer and a good chunk of autumn.

Click to enlarge

Continue reading the full article at Seeking Alpha here.

Clarifying What Is Meant By 'Lender of Last Resort'

As the European debt crisis continues to worsen there are growing calls for the European Central Bank to purchase ever greater quantities of Italian and other troubled sovereign debt. Berkeley Professor Brad DeLong recently wrote a widely discussed piece arguing that the ECB is failing in its central banking duty as 'Lender of last resort'. But is it?

Professor DeLong makes some good points, particularly about the importance of establishing credibility with the market. However, he fails to differentiate between a central bank serving as a lender of last resort to the banking system versus a lender of last resort to sovereign countries. So far as I know (central bank operations are often murky by design) the ECB has continued to serve as the former but has resisted becoming the latter. There is a big difference between the two so this is an important omission by Professor DeLong.

With respect to the European banks, the ECB has opened and accessed U.S. dollar swap lines with the New York Federal Reserve Bank while also providing certain "unlimited" lending facilities to European banks. In short, the ECB is in fact playing the role of 'Lender of last resort' to Europe's banks. However, as DeLong notes, the ECB has only purchased European sovereign debt in limited quantities. How come?

The Germans get blamed for the ECB's spendthrift ways, with the not-so-distant memories of the Weimar hyperinflation still weighing on Teutonic minds (or so the usual armchair-Freudian analysis goes). But there is some prima facie evidence for this hypothesis: even though the ECB has (so far) not chosen to crank up the printing press full-bore two German ECB board members have resigned in the past year. The most recent, Juergen Stark, publicly stated that his reason for quitting was the ECB's resumption of Italian and Spanish sovereign debt purchases.

While the ECB may continue to hold back for now I suspect that if things get extremely ugly it will in fact print a much greater quantity of money than it has to date to bail the Eurozone out of its debt problem. If this happens euro bulls beware.

The other alternative is for the proper lender of last resort to sovereign countries -- the IMF -- to step in. The IMF was in fact created precisely for situations like the current Eurozone debt crisis. Given this you might be wondering why the experts, in near unanimity, are instead pointing towards the ECB? The answer, in short, is because the ECB has a printing press and the IMF (for now) does not.

Other countries, such as China, do have the funds to bolster the IMF to bailout Europe. But they'll want something in return, such as a greater voting share on the IMF's Board. This is an unappealing prospect to the U.S. and (in particular) Europe, which has since the IMF's inception held a perennial lock on the top job at the Fund. And so in the minds of many that leaves only the ECB.

What If We Paid Off The Debt? The Secret U.S. Government 'Life After Debt' Report

This secret report was obtained through a Freedom-of-Information request by NPR:

The copy of Life After Debt we obtained reads "PRELIMINARY AND CLOSE HOLD OFFICIAL USE ONLY." 

The report was intended to be included in the official "Economic Report of the President" — the final one of the Clinton administration. But in the end, people above Jason Seligman decided it was too speculative, too politically sensitive. So it was never published.

Here's more:

The report is called "Life After Debt". It was written in the year 2000, when the U.S. was running a budget surplus, taking in more than it was spending every year. Economists were projecting that the entire national debt could be paid off by 2012. 

This was seen in many ways as good thing. But it also posed risks. If the U.S. paid off its debt there would be no more U.S. Treasury bonds in the world. 

"It was a huge issue.. for not just the U.S. economy, but the global economy," says Diane Lim Rogers, an economist in the Clinton administration.

The U.S. borrows money by selling bonds. So the end of debt would mean the end of Treasury bonds. 

But the U.S. has been issuing bonds for so long, and the bonds are seen as so safe, that much of the world has come to depend on them. The U.S. Treasury bond is a pillar of the global economy.

Banks buy hundreds of billions of dollars' worth, because they're a safe place to park money. 

Mortgage rates are tied to the interest rate on U.S. treasury bonds. 

The Federal Reserve — our central bank — buys and sells Treasury bonds all the time, in an effort to keep the economy on track. 

If Treasury bonds disappeared, would the world unravel? Would it adjust somehow?
"I probably thought about this piece easily 16 hours a day, and it took me a long time to even start writing it," says Jason Seligman, the economist who wrote most of the report.
It was a strange, science-fictiony question. 

Full story and audio clip here.

h/t Barry.

Default Myth Busting: Sorry Simon and James, the U.S. is not a Default Virgin

Professor Simon Johnson and James Kwak of The Baseline Scenario have an article at Vanity Fair about the geopolitical importance of credit in late-18th century France, Great Britain, and (especially) the United States. Their article, however, fails to mention an important detail which also happens to contradict their claim that "the (U.S.) federal government would always honor its debt".

The consolidation/conversion of U.S. revolutionary state debt into federal debt, which took place in the early 1790s, and which the authors refer to in the paragraph prior to the above quote, represented a U.S. sovereign default. (For more on this event see Reinhart and Rogoff (click on the U.S. tab) or Sylla, et al, which describes the 'haircut' bondholders received (6% to 4%).)

The notion that the U.S. has never defaulted has unfortunately been repeated often enough that, like the incorrect claim that TARP was "profitable", otherwise well-informed people have come to believe it.

In terms of other U.S. defaults, Reinhart and Rogoff also count Franklin Roosevelt's 1933 prohibition on owning gold and the subsequent devaluation of the U.S. dollar vs. gold as a default.

It's not very surprising to see Vice President Biden promoting the myth that the U.S. has never defaulted (in his case following a visit to the U.S.'s largest creditor, China). Professor Johnson, however, should know better.

Video: Niall Ferguson on the Likelihood of a China Hard Landing

Video after the break.

QOTD from World's Largest Currency Trader, John Taylor: "The euro is going to hell"

Here are some other highlights:

So why should the U.S. dollar appreciate in such a horrid environment? As the world's reserve currency, Taylor says, the dollar has become a reverse indicator of the globe's economic health. "Whenever things are good in the world, [the] currency goes down," since there's ample liquidity. But when the rest of the globe is doing poorly, there's no liquidity and therefore the U.S. dollar is worth more. "That is the most important thing to know about foreign exchange nowadays–it is kind of backwards," he says. 

Greece's default is more a matter of when than if, he says, as the Greek citizenry won't support the austerity measures necessary to stay in the euro zone. There will be a referendum this autumn on some of the recent changes, and the outcome could upend the fiscal cuts already decided upon, Taylor warns. 

He now sees the euro trading between $1.37 and $1 over the next 18 months—nearer to the top side "if the Fed does its best at ruining our currency, and the euro manages to survive somehow." The world is pretending the European debt crisis is fixed, he adds—necessary if you are trading short term, but "long-term, a debt deal isn't going to work. The euro is going to hell. Every time they do things to fix it, it gets deeper and deeper." 

Are there any other currencies worth paying attention to? Taylor is positive on the commodity-based ones, such as the Australian and New Zealand dollars, despite their run-up. "We use commodities to forecast currencies," he notes. For instance, Norway's krone is a function of the price of oil, which he thinks is a solid long-term bet on the next growth cycle. In five years, he says, "we could see oil at $500 a barrel. I would be a buyer on dips of oil." 

Among Taylor's influences is the 1991 book, Generations, by historians William Strauss and Neil Howe, which identifies longer-term cultural and demographic cycles in American life. "Every 80 years, we go through a deleveraging cycle," he says. "It's hard to measure, but that's where we are now. It has to do with the period 2010-20, compared with 1930-40." The so-called Millennials, who were born between 1980 and 2000, "will be the ones to save us, but they'll have no money, no entitlements," says Taylor.

Full article here. 

Video: Soros (Best Case Scenario) 2-3 European Countries Default/Leave Euro

And oh btw, the U.S. has probably already entered a double-dip recession.

But the good news, according to Soros, is that government authorities have learned from Lehman and will bail out Too Big to Fail firms when the system collapses again. In other words, the so-called 'Bernanke put' is not kaput.

End Game: Greece to Default This Weekend?

While the Greek government is publicly denying it (I suppose they have to until the banks close) the game appears to be up (further confirmation from Spiegel here).

The timing of the default would come roughly in line with my prediction. We're also seeing a softening in the euro, now down to $1.36, also as predicted.

In terms of what happens next, the first step following default would likely be a bank holiday in Greece. This would then be followed by some type of devaluation (rumoured to be around 50%) of the reintroduced drachma.

As I posted yesterday, anyone in Greece who still has their euros in a Greek bank may want to move swiftly.

Here is Professor Eichengreen with some deeper perspective and why its likely the ECB is going to be doing a lot of Ctrl+P.

Book Review: 'Sustainable Wealth' By Axel Merk

Axel Merk’s Sustainable Wealth is very readable personal finance guide to today’s increasingly complex investment world. The book contains a wealth of practical information, and it can be particularly useful for novice investors who are interested in learning more about the role of macro forces and currencies, and how they influence markets.

About the Author

Axel was born in Munich, Germany and grew up in a family of investors. It was during college that he first began investing on behalf of clients. His academic training is in finance and computer science, and he has lived in many parts of Europe before relocating to the U.S. He is the founder and CIO of Merk Investments, a Palo Alto, California based mutual fund focused on currencies. In his personal life he is a distance runner and pilot, and he is married with children. Axel Merk also gives regular media interviews and periodically writes for SeekingAlpha.

Sustainable Wealth

With his book, written following the financial crisis in 2008, Merk aimed to reach an audience that is intelligent and interested but not necessarily educated in economics or currencies. While Merk runs a currency mutual fund, the book is not aimed at currency traders. Rather the book primarily targets the man in the street who is concerned with the actions of today’s policymakers. In the book Merk describes the pressures between where the market would like to go and the interference run by policymakers. Understanding this pull-push dynamic is at the heart of Sustainable Wealth.

One of the key themes of the book is the idea that “there is no such thing as a safe asset” and that investors may want to take a diversified approach to something as “mundane as cash”. The book contains a number of helpful, easy to understand explanations about the fundamental nature of the world’s current debt problem, and ways to address it on a personal level.

During an interview, Merk emphasized his independent opinion. That certainly can bee seen with his often seemingly minority view on the euro versus the U.S. dollar over the past 12+ months. Other than the temporary slide in the euro last summer to $1.18, Merk’s view on the euro has more or less proven correct. However, it is worth keeping in mind that Merk runs a currency mutual fund inside the United States, and that one of the ways in which more American investors would take an interest in his fund is if they are concerned about the fate of the U.S. dollar.

Continue reading the full review at SeekingAlpha here.

Barry Eichengreen on What Could Replace the U.S. Dollar

Professor Eichengreen explains the current state of the world's reserve currencies and makes the argument for GDP-indexed bonds here.

Chart of the Day: U.S. Debt Ceiling Over Last 30 Years

Video: Barry Eichengreen on Why Economics Needs History

Berkeley Professor Barry Eichengreen discusses the importance of history to the study of economics and other topics in the below video.

A summary of Professor Eichengreen's recent book, Exorbitant Privilege, can be found here; a video lecture he gave on this book can be viewed here. 

So far Germany's current generation of leaders seem to be as committed to supporting the current Eurozone project as Professor Eichengreen has suggested they would . However, it's less than clear to me whether Germany has the appetite or capacity to support countries such as Spain and Italy should a full blown debt crisis ignite in these two large countries. Perhaps Germany would prefer a smaller Eurozone, comprised primarily of more economically homogeneous northern European countries instead of the current version which includes slow growing Club Med countries?

Why Bankrupt America Needs a Third Political Party

From Boston University Professor Laurence Kotlikoff:

The Republicans and Democrats have done a terrible job of managing our country and economy, transforming the American dream into a nightmare. They’ve squandered our youth and wealth in endless wars we couldn’t win, and spent six decades running an intergenerational Ponzi scheme, racking up huge official and unofficial debts for our children to pay. 

By some measures, the U.S. is now in worse fiscal shape than Greece. True, our official debt is a much smaller percentage of economic output. But our unofficial debt is much larger. The unofficial debt includes primarily the obligation to pay 78 million baby boomers roughly $40,000 a head each year of their very long retirements in Social Security, Medicare and Medicaid benefits. To get our overall fiscal gap under control, the U.S. must cut spending or raise tax revenue by $20 trillion over the next decade, far more than either the president wants or the House Republicans seek.

Full must read op-ed at Bloomberg.

Video: Jim Grant - 'We Traded the Gold Standard for the PhD Standard'

Interview with Jim Grant on Bernanke's press conference today, the coming of QE3, and why the Federal Reserve should "be run by someone with a degree in unintended consequences" after the break.

Video: Jeff Gundlach On What's Better Than Gold if Financial Armageddon Strikes

Will Central Bankers Have the Same Courage On the Way Out?

Exit interview here with outgoing Fed Governor Kevin Warsh, who openly discusses his skepticism of QE2, how inflation is the cruelest tax of all, and other topics.

On the Fed's long talked about but still distant plan to 'exit', or unwind, its unprecedented monetary stimulus, he states "Central bankers must have the same courage on the way out that they had going in".

But just how likely is that? Given the current unemployment situation, and the Fed's dual mandate of stable prices and low unemployment, the Fed seems destined to remain in neutral or biased towards putting it's foot back on the money printing pedal.

The Fed has now surpassed China as the largest holder of government debt and has made it abundantly clear that its weak U.S. dollar policy, hashed in the interest of kickstarting exports, is not really open to negotiation.

Bottom line: don't expect the Fed to have the same courage when (or if) it belatedly decides to exit its massive monetary stimulus.

Can the U.S. Government Stop Silk Road and Bitcoin?

No sooner than a week after widespread news broke describing Silk Road, a website which some are calling the Amazon.com of online illegal drugs, we have two U.S. Senators seeking to pull-the-plug on the site and the peer-to-peer virtual currency used to pay for drugs called Bitcoin.

ArsTechnica has a nice summary of Bitcoin:

Bitcoin is a virtual currency, designed to allow people to buy and sell without centralized control by banks or governments, and it allows for pseudonymous transactions which aren't tied to a real identity. In keeping with the hacker ethos, Bitcoin has no need to trust any central authority; every aspect of the currency is confirmed and secured through the use of strong cryptography. 

Over the last few months, Bitcoin's value has risen by an order of magnitude as the sagas of Wikileaks and Anonymous (among others) have highlighted the limits of a financial system which relies on centralized intermediaries. With a current estimated market capitalization of about $100 million, Bitcoin has recently graduated from a theoretical techno-anarchic project patronized by libertarians and hackers to a full-fledged currency prompting comment from technologists and economists. At the time of this writing, one Bitcoin (BTC) is worth about US$15.

Here's the original Bitcoin white paper published by Satoshi Nakamoto.

Can the U.S. Government Stop Silk Road and Bitcoin?

Government has had success shutting down centrally managed peer-to-peer services, like Napster. However, 'pure' peer-to-peer sites like Gnutella and Tor, have proven more difficult. Data and services can simply move from a server in one country to another, and pure peer-to-peer is widely distributed by it's very nature. In short, it could prove extremely difficult for the DEA to take down Silk Road.

Bitcoin, however, does link back to actual bank accounts, which perhaps leaves more room for the government to maneuver.

I should have more to say on Bitcoin in the not too distant future.