The Cost Of Profit

Posted on March 31, 2020 by thezman

Every businessman understands that every dollar of revenue that comes in has with it a cost required to earn it. If the business provides a service, then the biggest cost of sales is the labor required to provide the service. If the business sells a physical item, then the cost of making or acquiring the item is the big driver. There are indirect costs like rents and administrative expenses, but the starting place for any business is the cost of sales, as that is what ultimately determines profits.

There is another cost that is important, sometimes the most important, that does not show up in the financials. That is the cost of profit. This is an intangible cost. What unpleasant things do you have to do in order to make a profit? Maybe you have to be terrible to your employees or tolerate nasty customers. You can make a nice living running a pawn shop, but most people don’t think it is worth having to deal with the sorts of people, who avail themselves of the pawn shop.

As a society, this concept is easier to quantify, or at the minimum articulate, as a society has a shared morality. There is an agreed upon set of things that a society wants to minimize and a set of things it promotes. It may be better for the economy to rely upon slave labor in certain kinds of agriculture, but the moral cost of slavery is too high to contemplate such a policy. One reason manufacturing was shipped abroad is the cost of the pollution and the aesthetics was too high for our rulers.

The point is that certain types of economic activity may be lucrative for the people in that business or for the economy as a whole, but the intangible cost is too high. It is not just the moral cost either. There is the cost of risk. To allow certain types of lending, for example, puts the credit system at risk, so we forbid it. The cost of profit can also be the long term risk it poses the society, which generally means the cost that will be imposed on future generations when those risks become real costs.

A good example is the very lucrative basis trade popular with hedge funds, where they buy US Treasuries, while selling equivalent derivatives contracts. There is a small difference in price between the two, but when done in volume and with cheap credit, the profit to the hedge fund can be enormous. This is great for the private investors in the hedge funds, but it has huge risks for the economy. The recent bailout by the Federal Reserve is a good example of socializing the cost of profit.

This is just one example of economic activity that is profitable to the people doing it and good for those GDP numbers. It’s also high risk and therefore has an unacceptable cost for the profit gained. Throughout the financial system we see high risk strategies that can be highly profitable and serve some important purpose, like lowering the cost of borrowing, but bring with them unacceptable risks to the system. Socializing the cost profit through bailouts does not make it go away.

Another example of how the cost of profit works in the financial system is this story from Reuters about Capital One. This is the bank that peddles high interest rate credit cards to poor people and non-whites. They can specialize in high risk borrowers, because they charge mafia-esque interest rates. That covers the cost of collecting from deadbeats and the inevitable defaults. It turns out another one of their activities was gambling in the commodities markets, namely the energy markets.

Now, the obvious question is why is a credit card company that preys on dumb people playing at the high stakes tables in the commodities casino? Betting commodities is like playing at the baccarat tables in Monte Carlo. Actually, the odds are better in the casino, as the odds of winning are just 1.23% lower than the odds of winning a hand. The answer, of course, is the potential profit for the bank was huge, just as long as energy process never fell below a certain level, like they have recently.

As American states lost the will to directly tax their people, especially their rich people, they turned to indirect ways to fund government. One is the legalization of gambling, especially state-owned casinos. Since every state is in the gambling racket, a new type of casino has evolved. This is one with a grand shopping mall and Potemkin town center attached, so people can dine and socialize. The idea is to get everyone under one roof in order to encourage more consumption.

This model is the symbol of modern America. Our economy is a massive shopping mall, an international bazaar operated by traders from around the globe. Attached to it is a massive casino called the financial system in which the profits from the bazaar are wagered on increasingly high stakes bets. It has become so unstable that the landlord, the Federal Reserve and central government, has to keep stepping in to keep everyone afloat. It is a high tech, high stakes palace economy.

This is very profitable for the nation’s rich people, which get to enjoy luxury unimaginable just a couple generations ago. Even Louis XIV could not have rode out a pandemic aboard his floating castle. Meanwhile, the cost of such luxury will be his fellow citizens (does he consider them his fellow citizens?) lining up for miles to get food distributed by the local food bank. The price of such profit in terms of risk and inequality is simply too high to tolerate much longer.

In times of want, people are forced to think hard about their priorities. The same is true of a people facing a crisis. The Great Madness over the plague is going to send the economy into a depression. The West in general, but America in particular, is going to have to decide if the cost of profit, the cost of this high stakes casino economy, is truly worth it. Is this how we want to live? For what shall it profit a man, if he shall gain the whole world, but lose his soul?

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Over Stimulated

Posted on March 25, 2020 by thezman

The news brings word that Washington has agreed to an unprecedented economic package, estimated to top $6 trillion. This includes the $4 trillion in money the Federal Reserve will hand to rich people through various ways. The other money will go to different rich people in the form of tax rebates and cash payments. Some very small amount will go to everyone else in the form of unemployment checks, loans to small business and one time crazy checks randomly mailed to people.

The money in the stimulus bill is not all a waste. Bailing out the airline industry has a real benefit. Airlines are like a hybrid utility these days. They are technically private companies, but almost all of their actions are controlled by government. They operate through state owned airports and every aspect of their operations must be agreed to in advance by the federal government. We need the airlines to function, so bailing them out has some actual value to the rest of us.

As an aside, you’ll note what is not in this bill. If we are throwing trillions around, it would make sense to build a wall along the border or maybe fix up some roads. Perhaps we could draw back some overseas commitments and put those funds to work rebuilding the homeland. While the checkbook is open, maybe Trump could get something for his voters this time. Instead, you can be sure, tucked away in the details, will be money for more dirty barbarians to be settled in your town.

The stimulus bill is just the show. Its main purpose is to show the public that the actors and actresses hired by rich people to play the role of congressmen and senators really care about the people. The other carny folk post videos of themselves enjoying quarantine in their mansions. The carnies in DC pass stimulus bills. That may sound very cynical, but everyone in small business knows the score with these rescue packages passed by Washington during a crisis show.

The real mischief, however, is in the other money being handed to the nation’s desperate rich people. This is the stuff being done by the Federal Reserve, away from the TV cameras. Trillions of dollars will be poured into the financial markets, much of it through the direct purchase of assets, like bad debt, stocks, corporate bonds and the synthetic stuff no one really understands. The central bank is coming close to turning the global financial system into a palace economy.

A palace economy is a form of economic organization that was common in the Bronze Age societies of Mesopotamia and the Mediterranean. This is a system where a substantial share of the wealth flows to the rulers and is then distributed to the general population. The proceeds of farms, less what the farmers feed their families, goes to the king, who then feeds the people. The same holds for booty gained from conquest of neighbors or the mining of precious metals.

Now, the Federal Reserve is not taking these assets against the will of the current holders and then giving them to the rest of us. Instead, they are paying face value for assets that may or may not be worth what is claimed. The plan is to flood the system with cash in order to prevent cash hoarding. Theoretically, this keeps the banks lending and the credit system moving. In a system entirely based on leverage, any interruption in the credit system threatens the life of the system.

This reveals the big lie about modern economics. Small and mid-sized business are exposed to the dangers of the marketplace. If they make a mistake, they pay for it and possibly go under. In the major leagues, where the big boys play, there is no threat from market forces, as the Federal Reserve backstops everything. It is not a marketplace, but rather a highly complex casino, where the house stakes all of the players. Those that lose are simply given a loan from the house to keep playing.

A good example of this is something that started happening last fall, before anyone cared about the Chinese virus. This was back when the Fed mysteriously began to intervene in the repo market. No one had a good answer for why this was happening and the financial media was told not to ask too many questions. It turns out that it was a quiet rescue of hedge funds. They had over-leveraged themselves working a popular skim called the basis trade. The Fed jumped in to save them.

Just as democracy is a farce to conceal who is really calling the shots, free market capitalism is just a show to conceal the reality of the economic system. The response to the panic they have created shows just how little of the economy is actually a marketplace at all. The $6 trillion in stimulus is a quarter of the economy, on top of the mountain of regulations and trillions in normal government spending. In America, the “free market” is a fringe activity reserved for the little people.

It is tempting to think that this reality is some sort of perversion of our ancient economic traditions, but that’s just another pretty lie. In reality, the normal state of things is for the rulers to tightly control the economy of their territory. In was true in the palace economies of the ancient world. It was true throughout the middle ages. It has been true in the modern world since there has been a modern world. Like libertarianism and communism, the free market exists only in the mind.

Knocking At The Door

Posted on March 7, 2020 by thezman

One of the pitfalls of dissident politics is the temptation to succumb to despair, focusing only on the negative. Excessive cynicism is an escape, an indulgence, like libertarianism, where you get to pretend the sideline is the high ground. Cynicism is a cost free way of both participating in politics, but standing outside of it, as if you are above it all. It has been a feature of modern conservatism as a way of keeping the people from noticing that they are being scammed.

The truth is, politics at this level is not about elections or public policy. It is about effective social change, by changing the frame of reference. That’s a lot like steering a super tanker into port. A little nudge here. A little there. In the moment, you see little progress, but eventually, the tanker does move. That’s the point of dissident politics in the current age. It is moving things a little here and a little there in the effort to make our target audience aware of what’s happening to them.

An example of one of those tiny little bits of evidence that the ship is moving a little bit our way is this post from NRO, of all places. It is an interview with Oren Cass, who is the director of a new think tank in the Imperial Capital. The mission statement of American Compass says it is “to restore an economic consensus that emphasizes the importance of family, community, and industry to the nation’s liberty and prosperity.” Put another way, they claim to oppose what we call marketism.

Another Washington think tank is hardly an inspiration to our side, but Oren Cass has gotten a lot of attention from influential people. This twitter thread spelled out the problem of worshiping economic data as an end in itself. More important, he did so in the language technocrats can understand. That is an important step, as it introduces dissident topics to people lacking the language and mental constructs to understand much of what is discussed on this side of the great divide.

A good example of this is the response from another NRO pod person to that Oren Cass twitter thread. Like so many in that hive, he clearly does not understand the concept of trade-offs. He certainly is clueless when it comes to concepts like social capital or community capital. He’s stuck at the place where knowing that the big number is more than the small number gets a gold star. Still, Cass is able to speak to him in language he can grasp, which is important.

Now, this does not signal a revolution of thought inside the Imperial Capital, but it does suggest some people inside are looking over the divide to this side. More important, instead of just assuming the people on this side of the great divide are evil or stupid, they are wondering why so many people are heading this way. The first step to legitimacy is often when the people in charge simply start taking their critics seriously, rather than treating them as a pestilence to be eliminated.

To be clear, Oren Cass is not “one of us” and never will be. In fact, if the inner party decides to round us up and ship us off to camps, he will be right there with them, as he is them and not us. The ruling class, along with their attendants, define themselves in opposition to us. Who they are is explicitly not us. They are the occupiers, the colonial pod people, ruling over the rest of us. Oren Cass and his project are simply a flicker of doubt, a sign that all is not well inside the walls.

A sober minded person would wonder why it has taken so long for anyone inside the walls to notice the problems outside the walls. After all, paleo-conservatives were predicting these sorts of problems forty years ago. Pat Buchanan ran on these issues, as well as Ross Perot. Trump is in the White House, in large part, because of the economic realities just dawning on people inside the walls. Heck, Bernie Sanders exists because of the things Cass identified in that thread.

It is the big tanker ship. A thing normal people cannot grasp is just how different the world inside the walls is compared to regular America. In the Imperial Capital, it is always a booming economy. Every day is Fat Tuesday, because tomorrow is always fat Tuesday as well. It’s always good times in the Washington for people who make their living in politics. Imagine a college campus the size of a city, but instead of students roaming about it is adult who work in politics.

This is why all past political reform efforts have failed. When the road goes on forever and the party never ends, reform sounds like ingratitude. From the Tea Party to the Bernie Bros, to the people inside, these movement strike the revelers as irrational ingratitude by people who don’t know how good they have it. But, the dissident right is knocking at the door and some people are starting to listen. It is a tiny example of how things are moving our way, ever so slowly, like that tanker ship.

The Great Consolidation

Posted on December 26, 2019 by thezman

One of the more important trends in post-Cold War America is the great consolidation that is going on all areas of life. This past Christmas shopping season, for example, was great for a small number of giant retailers. Amazon certainly had a good shopping season, as well as some giant operators like Walmart. For the small local retailers, Black Friday was not the start of their boom time, but a continuation of a decline that started in the 1990’s and continues unabated.

An adult in 1985 would probably have done business with a dozen different retailers during the season, in order to get the gifts and supplies he needed. He would have gone off to a mall to walk through dozens of shops. He would have hit the bigger retailers, of which there were many. That mall would have had two or three big stores, in addition to many small retail chains. Most people had access to two or three malls, in addition to small retailers operating in older strip malls.

This past Christmas, many people will have done all of their shopping on-line and some of those will have done their business with just one company. You can buy just about everything you want from Amazon. If they are not the direct seller, they are operating as a fulfillment company for others. They also operate storefronts for those who just a few years ago would have had their own web store. Amazon and Walmart are close to owning the entire on-line marketplace in the United States.

Consolidation is, of course, a feature of capitalism. An important thing libertarians always miss is that markets naturally seek to consolidate. No matter what set of rules are agreed upon in the market initially, dominant players will emerge and seek to consolidate their grip on the market. Eventually you end up with a few players that control the supply side of the market, thus turning the market into the modern version of the Bronze Age palace economies.

This tendency toward consolidation is not just turning up in the retail side of the American economy. It is occurring in the wholesale side as well. The industrial supply sector has seen a great consolidation in this age. Regional players have been backed by investment bankers toting unlimited credit money, so they can buy-up the smaller players. The supply chain has also seen a similar consolidation, where local operators are displaced by global operators.

The relentless drive toward consolidation is not just an economic trend but a cultural and political one as well. For the first time in a very long time, the children of middle-class Americans can expect a lower standard of living than their parents. One reason for that is the consolidation in the professional ranks. That great consolidation in the economy has meant relatively fewer jobs in the middle and upper management ranks of American business and in the professions.

That’s something that has gone completely unnoticed. In the 1980’s, going to a top-25 law school meant an upper-middle class life, even for the slacker. If you could not cut it at one of the elite firms, you were going to land in regional or local firm, where you could expect a comfortable life. There is a now a great consolidation in the law that will accelerate in this decade. Not only will the number of spots in the elite get smaller, but the next levels down will disappear entirely.

Another area where this will happen is higher education. In a way, higher education has been a relief valve for the children of the top-10%. Those unable to get into elite law schools or cut it in the law of finance, could land a comfortable life in a university either as an administrator or professor. The number of tenured professors and senior administrative staff continues to shrink relative to overall staffing. Of course, the college finance system is about shrink the whole system.

What we are seeing is something no one worried much over in the 20th century and that is the collapse of the upper-middle class. The focus was always on the working class and the great solid middle. While the working class has been obliterated as a social unit, the middle-class has struggled on. Where there is a crisis is in the upper middle, the class of people who served as the staff for the ruling class of American society in business, the professions and politics.

The great consolidation at the very top, is going to mean a great consolidation in the class that serves the top. In a world of ten thousand local guys like Jeff Bezos, there was demand for ten thousand top assistants. In a world of one Jeff Bezos, there is only one aid and maybe a support staff for that top man. That’s a bit of an exaggeration, but it reveals just how much damage consolidation at the top does to the next strata of society that exists to serve the elite.

There is another consequence to this great consolidation. The children of professionals, who are unable to find a spot in their class, tumble into the next class. This changes the that class. The radicalization of the white middle-class we see happening is due, in part, to this consolidation. All over in dissident politics are men who would have been in management tracks, partner tracks and tenure tracks. Instead they are working outside that system and exercising their minds in dissident politics.

This will have consequences. One way of viewing the revolutions set off by the Enlightenment is that they were the result of idle smart people. The American Revolution and the French Revolution were led by smart fractions. In a world of global oligarchs, where the smart fraction is coalescing outside the ruling fraction, the result will be increasing social unrest. The great populist revolt of the past decade is probably just an appetizer for what lies ahead in the new world order.

Repo Men

Posted on December 17, 2019 by thezman

There used to be a time when the mass media covered the Federal Reserve as if it was Hollywood or a professional sports league. Whenever the Fed acted or the Fed chairman made a statement, it was big news. That has not been the case for a long time, mostly due to the mortgage meltdown. Worshiping the money men was no longer good copy after they came close to blowing up the world. Halfway through the Trump tenure, the media barely mentions the Fed or Fed policy.

Still, the central banks remain the most important government institutions on earth and this is particularly true of the Federal Reserve. They control the global economy, because they control the supply of money and credit. This is why the massive intervention into the credit markets by the Federal Reserve recently should be front page news. Something very big is happening and no one seems to know why, but the Fed is responding to it with $500 billion in new money.

Now, they are not just printing up cash and throwing it out the window. Instead, they are intervening in the repo market to head-off a market crash. For those who don’t know, the repo market is not where repossessed items are sold. The word “repo” is slang for repurchase agreement¹. A repurchase agreement is a short-term funding mechanism where one party needing cash, sells an asset to a party for cash, with an agreement to repurchase the asset at an agreed upon price.

A repurchase agreement functions in effect as a short-term, collateral-backed, interest-bearing loan. Much of what happens in the world of investment banks is reliant on the repo market. In order for these entitles to function, there has to be enough cash available in the system for these transactions to occur. Otherwise, borrowing rates go up, which means the cost of doing business goes up. Taken to the extreme, no cash available means the credit markets lock up.

Since the financial system is like a watch with gears interlocking with gears, one gear seizing up has the potential to seize up all the other gears. A frozen repo market could result in a cash crunch for banks, which locks up business and retail lending. That locks up the Main Street economy and we’re looking at bread lines. The economy, as we understand it, relies on a steady supply of money and credit freely flowing through the system according to the rules established by central banks.

As an aside, if the repo market probably sounds a lot like a pawnshop to you. A pawn shop offers short-term, collateral based loans. You take the family silver into the pawnshop and they give you cash. You agree to come back with the cash, plus interest, to get the family silver out of hock. If you blow the cash on a sure thing and are unable to pay the pawnshop, they take ownership of your item and sell it for cash. So yes, the financial system is built on the logic of the pawnshop.

Now, this move by the Fed is very curious. Clearly, something has caused this problem in the repo market, but no one seems to know the cause. It’s serious enough that the Fed’s balance sheet, currently at $4.1 trillion, will surpass its all-time high of $4.5 trillion. For several years now the Fed has made clear its intent to shrink its balance sheet. Therefore, this problem is serious enough to cause the Federal Reserve to change course and blow up its balance sheet.

The question is, what’s going on?

One possible answer is bad rule making over the last decade that has rewarded banks for hoarding cash. Instead of lending to one another, they are sitting on cash reserves. The risk-reward is better than short term lending. This could be due to a combination of market factors created by Fed policy and regulations on banks regarding their cash reserves. In other words, the government has created a distorted short-term lending market, through regulation and Fed policy that discourages short-term lending.

Another, more worrisome cause is that central banks have built a low-interest rate trap for themselves that they cannot escape. In lowering rates and intervening so aggressively in the market to stave off collapse a decade ago, they have created a system that cannot exist without low rates and aggressive intervention. Efforts to restore rates to historic norms or attempts to shrink the balance sheets of central banks threatens the very existence of the global financial system.

In such a scenario, the system controlled by the central banks becomes increasing complex with every intervention. Currently, the Fed does not know why the repo market is broken. They are simply reacting to the short-term effects. Their actions, however, will be part of the problem to be solved, a problem they don’t fully grasp. By the time they do understand the issue, they may have been forced to make additional interventions that further change the complexity of the problem.

Of course, a world of permanently low interest rates and unlimited intervention by the central bank is not a world controlled by the central bank. Rather, the central bank is now controlled by the system it created. The main weapons the central bank has used in the past to address systemic failure are no longer available. Taken to its logical conclusion, the financial system is a run-a-way train. The Feds do what they can to keep it on the tracks, but eventually, the inevitable happens.

In the long run, the story of credit money may be that it is simply a complex way to pull forward the benefits of economic activity, for the benefit of a few. Eventually, all of the pain avoidance with low interest rates and central bank intervention consume all of the economy to pull forward. Those accrued costs are reversed out all at once and system collapse in the result. The resulting political fallout then topples over the liberal democratic order and we enter an entirely new age.

That may sound overly apocalyptic, but consider how political institutions must weather a crisis. The people must not only want to preserve those institutions, they must trust the people running them. A great systemic collapse of the economic order would need a lot of trust in the political order to avoid revolts. At no time in the West has the current political order be less trusted. It needs the good economy to survive. That sound a lot like a house of cards waiting for the wrong decision.

¹Short primer on repurchase agreements.

The China Questions

Posted on August 25, 2019 by thezman

The trade war with China is heating up, so the usual suspects are now turning up in the media to pronounce on the issue. There is the sense that many of the pundits are relieved to take a break from discussing the culture war that surrounds the Trump presidency and the Progressive response to it. Talking about trade and global economics feels like old times. Here is a longish post from David Goldman, the man behind Spengler of the Asia Times, addressing the trade war.

As is always the case in these matters, the Michael Crichton observation about the media should be kept in mind. The growing rift between China and the United States is a complicated matter by itself. The impact it will have on global trade, the US economy and geopolitics is even more complex. Even people paid to risk real money in these areas don’t have a firm grasp of all the moving pieces. The people posting in the media know even less. Often they know nothing at all.

That does not mean there is nothing we can know. The first question, in any heated trade dispute between two countries, is “who is buying and who is selling?” and the related question is, “What is being traded?” In this regard, trade disputes are not a lot different from disputes between customers and vendors. How they proceed and how the end is entirely controlled by the relationship and the products in question. That determines who has the most leverage in the dispute.

In this case, the relationship is easy to sort. U.S. imports from China totaled $539.5 billion in 2018. U.S. exports were $179.3 billion. That export total is about 7% of all U.S. exports for 2018. Put another way, the U.S. market is about 5% of the Chinese economy, assuming the fake Chinese economic numbers are even close to reality, which is surely not the case. The Chinese market is less than one percent of the U.S. economy in 2018. Imports are about 3% of the U.S. economy.

Right away, the relationship between China is the U.S. is not an equal one, in terms of dollars, but also in terms of impact. Then there is the nature of trade between the two countries. Almost all of the U.S. exports to China in 2018 were aircraft parts, electronic components and car parts. In many cases, these are either high precision items the Chinese cannot produce or they have intellectual property that the Chinese will try to steal, so they are made in the U. S. and sent to China.

This is why Trump is playing hardball. He believes he has far less to lose than the Chinese in a trade war. Even if all trade with China comes to an end, the cost to the U.S. economy is not going to be devastating. In fact, it will be hardly noticed. Much of that trade will be replaced with other cheap labor countries, as it is not really trade in the conventional sense. America’s economic relationship with China is about off-shoring manufacturing to dodge labor, tax and environmental laws.

This is a point that cannot be made enough. When American producers sell good to Canada, and Canadian producers sell good to America, that’s trade. When American producers move manufacturing to Mexico, then bring those goods back home under a tariff free regime, that’s not trade. China is not selling the world anything the world does not have or cannot make. What China is selling is a safe haven to avoid the labor, tax and environmental laws that exist in the West.

That does not mean there can be no impact. That’s the other set of questions that can be examined from the outside. China can play a long game, as the Chinese leaders are not facing annual elections and endless media scrutiny. The West, particularly Trump, are in an endless election cycle. Any little blip in the economy is magnified by the media and then fed into the political calculus. While this trade war will inflict more pain on China, they have a much higher pain threshold than Trump.

That’s the theory. It is not all that clear just how much pain Trump will suffer from this standoff with China. The timing actually works in his favor. The slow buildup not only gives American business time to adjust, it gives the political class time to cast it as the typical good guy versus bad guy story. Xi Jinping is not exactly a lovable Jackie Chan type of guy, so casting him as a villain will be easy. In other words, Trump may be trading a little economic capital for a lot of political capital.

Then there is the question of just how much pain China can take and for how long. It is just assumed by Western analysts that the Chinese can absorb any amount of suffering for as long as it takes. After all, China weathered the Cultural Revolution without a mass revolt by the people. Mao had to die before the party moved to end the madness. Why would the Chinese people revolt over a slight down turn in the economy? Why would the party move against Xi Jinping, if the trade war contracts her economy?

No one can know this, but we do know that wealthy people are far more sensitive to small changes in the economy than poor people. We see this in the West. A small down turn has the middle class turning against their party, but a generation long depression in coal country has not caused a revolt. That same reality may be true in China. There are a lot of people living bourgeois lifestyles along the Chinese coast, all financed by one-sided trade with the United States and her allies.

While all of this economic 4-D chess will occupy the pundits, there may be a simple answer to what is going on with China. It could simply be that China has become a liability to the West. The benefits of moving manufacturing to China has been consumed at this point. What’s left is the liability, which is currency manipulation, IP theft, espionage and financial shenanigans. China is running out of friends in Western capitals. The appetite for tolerating this stuff may be waning.

The Uncertainty Of Money

Posted on August 22, 2019 by thezman

Imagine a world in which governments do business with one another only in gold, as in physical gold. They can issue promissory notes to one another, but it has to be backed by verified stores of gold. Governments, however, do not use gold for paying employees or contracting work with private business. In the case of employees, government pays in script, the value of which is set by the government. The vendors, on the other hand, are paid with silver, as in real silver coin or silver notes.

The first part of this thought experiment is not a big leap, as governments still hoard gold and will on occasion pay one another in gold. In our imaginary world, gold would be the exclusive currency of government, so regular people would hold very little of it, other than for novelty. This is not much different from today, as gold is not legal tender in most of the world. It is treated, in the law, as a commodity, like diamonds, barrels of oil, bales of hay, and so on. Gold is a product, not money.

The rest of the thought experiment gets a little weird, as companies do business in the tender of their home country. If they did business with one another in silver, then one of two things would happen. Either the price of silver would be pegged at the value of the legal tender or it would be pegged at the price of gold. Since government would always be willing to buy gold in silver or tender, from anyone holding gold as a store of value, the most likely result is all three would be related in value.

The result of this arrangement would be a world where the credit worthiness of governments would be pegged to their gold reserves, but also the gold reserves of their native companies and populations. A government that could quickly buy up gold from its people would have more flexibility than a government so distrusted that its own people would resist selling its gold to the state. Something similar would apply to the credit ratings of businesses, with regards to the supply of silver.

A well run country with a high trust population and a responsible government would find that the flow of gold and silver would be high, as there would be no reason to hoard them. Similarly, the value of the paper script used for retail transactions would have a steady value, relative to the currency of business and government. This would not just be an internal trust. Outsiders would see it too. In contrast, corrupt states with corrupt people would have low trust and lots of hoarding of gold and silver.

Now, this thought experiment is useful in understanding what is happening with the screaming headlines about negative bond yields. The media hypes these events as if they are the sign of the end times. Most likely, they are triggered by the word “negative” and just assume it is bad news. In reality, what the market is saying is that the German bonds are so safe, the holder is willing to pay for the privilege of holding them. Lenders are literally paying the German state for the privilege of lending to it.

Now, it is tempting for a certain sort of person (libertarians) to say it is ridiculous to compare government debt to gold, as in this analogy. They are right. Government debt is actually more secure. The reason is this. Tomorrow, the government can ban the private ownership of gold. Executive Order 6102 is a United States presidential executive order signed on April 5, 1933, by President Franklin D. Roosevelt that effectively banned the private ownership of gold in the United States.

On the other hand, no government anywhere could ban the private ownership of government debt. In fact, no government could risk the hint of not paying its outstanding debts, as that would make all debt worthless. Since, in the case of Western countries, those government bonds are the basis of the financial system, public trust in the credit worthiness of government is vital. That’s why people are literally willing to trade gold at a loss for the privilege of holding German bonds right now.

Now, that does not mean negative rates are all puppies and sunshine. Going back to our analogy, a world where everyone trusts government, but is not willing to trust companies, would result in a disequilibrium in the relationship between gold, silver and the paper script used in retail. The “price” in terms of script for silver would collapse, while the price of gold would soar. After all, why hold silver when business is bad, when you can hold gold or even cash, which has a higher value?

In our age, government debt is the gold in the analogy, but corporate debt is the equivalent of the silver. Modern business works off debt, as it is the currency of the modern age. In prior ages, government debt and corporate debt was captive to the supply of gold and silver. Today, the relationship between sovereign debt, municipal debt, corporate debt and legal tender is enabled and managed by central banks, primarily the Federal Reserve and the European Central Bank.

This is why borrowing rates across the West remain at historic lows. The whole point of this arrangement was to prevent the ups and downs, the booms and busts that plagued industrial economies since the steam engine. The trouble is, the system also allows for the easy manipulation of the economy through the money supply. Inevitably, that worked one way and we are now in a place where no one is willing to pay the price of getting things back to something close to historic norms.

This system has also been based on certain assumptions about America that are starting to unravel. One is that America would continue to operate like a giant shopping mall, willing to buy on unfavorable terms. Both Europe and China based their economic models on this assumption. Trump has abandoned that and that’s why we see problems in China and now economic uncertainty in the heart of Europe. The uncertainty of world political arrangements is now showing up in the money.

It also suggests the markets are slowly coming to terms with the fact that the Trump economic model is the new normal. The election is fourteen months away, so if his loss in 2020 was the safe bet, the markets would be responding now. Instead, the global economy seems to be slowly coming around to the fact that either Trump wins in 2020 or his polices will be carried on no matter what happens. America as problem solver for the world’s money problems may be coming to an end.

House of Cards

Posted on August 17, 2019 by thezman

One of the things that was revealed in the 2008 mortgage crisis was the fragility of the global financial system. The system that was born of the Louvre Accords was supposed to be robust and resilient, unlike the previous arrangements. The masters of finance would be able to keep a steady hand on the tiller, guiding the world economy through each storm, rather than have a free-for-all ever time there was a little turmoil. Up until 2008, everyone knew something like the mortgage crisis was impossible.

A credit based financial system was supposed to get around the problem of currency devaluation to solve political problems. That’s been a problem since the advent of coinage. When the state gets in trouble, the easiest ways to solve it is to spend money on the public. Whether it was debasing the coinage or printing paper money, the solution to spending money that did not exist was the create it. That always created new and bigger problems for the society down the line.

One way of looking at the mortgage crisis is as a form of currency devaluation. The global financial system is based in credit. That’s the base unit of value. Government debt and to a slightly lesser degree, corporate debt, is the foundation of the global financial system. Government issues debt, which increases the supply of money in the system, as that debt is used as collateral in the system. Central banks can buy and sell debt to control the supply of money in the system.

What no one thought much about, it seems, is how players in the system could devalue credit, in the same way governments devalued currency. That’s exactly what the mortgage brokers were doing. By lowering credit standards for borrowing, they were debasing a fundamental unit of currency in the system. This went unnoticed for a long time until everyone started noticing at the same time. The panic to unload the debased currency – those bad mortgages – set off the mortgage crisis of 2008.

That’s something to keep in mind as the next crisis appears on the horizon. The Wall Street Journal ran a story on General Electric’s financial issues. It’s based on a report by independent watchdog Harry Markopolos, who got famous sounding the alarm over Bernie Madoff’s scheme. For those familiar with global corporate finance, it is an interesting read, as GE is the exemplar of corporate legerdemain. It is not unreasonable to say that GE exists to exploit gaps in the regulatory system.

General Electric is one of those companies that looks like one thing, but in reality is just a financial scheme masquerading as a legitimate business. For example, their stunning growth in the 1990’s was not due to great manufacturing innovation. It was the result of GE Capital, a banking arm of the company. This arm not only financed their clients, who bought GE products, it financed GE’s expansion through acquisition. Without GE Capital as its credit creation vehicle, there would be no General Electric.

When you dig through the report, there are the familiar signs from the 2008 crisis. The allegation is GE is exaggerating one side of the balance sheet and minimizing the other, in order to make its liquidity appear much higher than reality. The whole point of this is to maintain a credit rating that allows it to borrow at competitive rates. Those lenders are not all that interested in the facts behind those numbers, as they have no incentive to examine the credit worthiness of General Electric.

Now, GE is one firm and maybe this is both exaggerated and isolated. That’s not the way to bet though. One of the ignored aspects of global business is that even tech oligopolies rely on a financing arm to exist. Apple, for example, is really a hedge fund that makes phones. Braeburn Capital is a wholly owned asset management company based in Reno, Nevada. Other tech giants are far less transparent, but every bit as wedded to the credit system to maintain their positions.

In theory, having global corporations as nodes in the global credit system is not a bad thing, because it makes them easier to regulate. In reality, as we saw with the mortgage crisis and now with General Electric, it also encourages everyone to overstate their credit worthiness. It also encourages opacity. The more complex and opaque the financial statement, the more costly the audit. Again as we saw with the credit agencies in 2008, the simple answer it to take the statements at face value.

That was the other thing revealed in the mortgage crisis. The system was a black box, even to the people inside it. The decisions makers in the big banks were unaware of what was happening upstream to pollute their asset pools. Of course, they had no incentive to care, so they never looked. Those people upstream had no way of knowing what they were creating downstream, but they had no reason to care. Regulators, of course, had no skill to examine the system and they did not care either.

Global debt, which includes government, corporate and household, is now 50% higher than it was at the time of the 2008 financial crisis. Due to the massive expansion of government debt, the stated quality of the overall debt is higher than in 2008, but this assumes government never runs out of money. Given that government solvency is tied to corporate and household solvency, that’s not an indisputable assumption. All anyone can really know is the world is awash in debt at all levels.

One read of the 2008 crisis was that it was a proof of concept. Instead of the system collapsing the world into depression and war, it withstood a huge blow and slowly eased the world out of the crises. The other read is that it was a warning about the internal logic of the system. A credit based economy is a house of cards. If the wrong card falls, the whole system collapses. It could be that the warning over GE is like the warning over mortgage lending. A warning to the house of cards.

The Cheap Credit Trap

Posted on June 5, 2019 by thezman

The Federal Reserve is making noises about cutting interest rates for the first time in several years. The reason is the trade dispute with China and now Mexico is potentially having an impact on the global economy. Even though it is only a signal of an intention, markets rallied on the news. Global investors and their robot traders love cheap credit from the Federal Reserve, so anytime there is the promise of more cheap credit, there is a rush into equities. It is a reminder of what actually drives stock indices.

It used to be that recessions were seen as a correctives for the system, as they eliminated unproductive and parasitic elements from the economy. In good times, all sorts of inefficiencies are tolerated, as everyone is making money. When times get tight, everyone gets serious again. Inefficient businesses and industries fail, thus putting those resources into more productive areas. The recession was the economy’s way of policing itself, so it was considered a necessary, if unpleasant, feature.

No one thinks like that today. Any sign of a downturn produces panic, especially among office holders. Part of it is no one has any respect for office holders, so voters will look for any reason to throw the bums out. For people who live off the public, losing an election is worse than death. Another part of it seems to be the sense among the ruling classes that they have only a tenuous grip on power. This is a bread and circus world now and they better make sure both are in ample supply.

That’s all speculation, of course, but it’s also a reminder of the long running problem that no one can figure out how to remedy. That is the interest rate trap. Lowering rates to address a slowing economy or a financial crisis is easy. Raising the rates back up again appears to be impossible. It has been over a decade since the mortgage crisis and the Federal Reserve is still trying to unwind its position and bring rates back up to historic norms. This news suggests they will never pull it off.

One reason the Federal Reserve is trapped in a world of ultra-low interest rates is the world economy is based on credit. The foundation of the credit system is U.S. treasuries. When the government borrows money, it is also creating an asset to be used in the financial system. Stable and predictable interest rates make treasuries valuable collateral, as their value will never decline. In fact, the market has an insatiable appetite for American sovereign debt. Those super-low rates are a big part of it.

Of course, the flip side of this is the U.S. government can only exists as it does with super-low borrowing rates. Current debt stands at $22 trillion and goes up by a trillion per year, give or take. Even if the so-called fiscal conservatives got all the items on their wish list, the cost of the great Baby Boomer retirement guarantees massive borrowing for the next several decades. That is only possible in a world of cheap credit, so both sides of the debt transaction need super-low interest rates.

Then there is the retail side. Whole industries have become hooked on super-low borrowing rates. Imagine what happens to housing if mortgage rates return to historic norms, in terms of interest rates and terms. Imagine what happens to the car business when car makers cannot offer 84-month terms and low interest rates. The answer is these industries shrink considerably and take the economy into a depression from which it would unlikely recover. These industries need low rates to survive now.

Now, there is an argument that borrowing rates are normal for a highly efficient modern economy. Historic averages are not useful, as the world where men paid debts with gold coin, or mortgages were processed by hand, is nothing like today’s world of automation and complex financial instruments. There is a lot of truth to this. Automation has not just made transaction processing faster, it has made it more reliable, thus reducing systemic risk and friction. Cheap rates are a reflection of cheaper costs in the system.

There’s also the fact that central banks have greater control of the global economy than at any time in human history. The microprocessor has had no greater impact on the world than in the financial system. Not only do central banks have more information about the state of the economy, they have tools that allow them to see trends before they get going, thus allowing them to anticipate problems before they reach crisis level. It’s not perfect, but managed capitalism is more efficient and predictable.

That said, the main tool central banks have in fighting a financial crisis is lowering borrowing rates. The reason they could soften the blow of the mortgage crisis is they could spread the cost of remedying it across the following decades. In the simplest terms, the Federal Reserve used a payment plan to cover the cost of fixing the mortgage crisis in 2008. That was only possible with the room to lower rates and borrow heavily from the private economy to soak up bad debt and warehouse it at the Fed.

Inevitably, this topic leads to questions about whether the current credit based economy is sustainable in the long run. The old joke about “in the long run, we’re all dead” is true here as well. The current monetary system has been in place since the Louvre Accords in the 1980’s. While there have been recessions, there have been no depressions that threaten the political order. The ability to borrow has never been stronger, which means the West should be able to manage the great demographic change over.

Still, there is that haunting sense that this credit regime is a slow-motion bust-out where social capital is turned into cash and used to perpetuate the current order. At some point, when the West is nothing but a shopping mall full of strangers, with no connection to one another, what happens then? The West is haunted by the sense that the true cost of cheap credit makes the credit based economy unsustainable. In the end, the cultural capital will have been exhausted and there will be nothing left to borrow.

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The Bandit Economy

Posted on May 8, 2019 by thezman

There is an old parable about business ethics, where a young ambitious man is hired to run a pickle factory. Being ambitious, he comes up with a brilliant idea to increase productivity. He reduces the number of pickles in each jar by one. The result is the cost per jar falls and the number of jars produced goes up. His bosses are suitably impressed and he is quickly promoted. The firm hires another young hotshot to take his place, he quickly figures out the scheme and repeats the process.

The lesson of the story is that such an approach is not really about increasing efficiency or cutting costs. It is about fraud and the limits of fraud. If this process is carried out a few more times, customers will notice that the jars have a lot less product. Taken to its logic end, the company will eventually be sending empty jars to the market. Of course, once the public catches onto the fraud, the good name of the company is ruined and all of those savings they gained on the front end are lost on the back end, plus interest.

It is a useful parable when trying to understand what has happened to America over the last three decades. Free of the threat of nuclear annihilation, the ruling class has abandoned ethics and morality. One result is we live in a bandit economy, where things like shrinkflation are features rather than exceptions. This post over at Zero Hedge details how the gas you put in your car has been systematically watered down over the last quarter century, coincidentally starting at the end of the Cold War.

Of course, a trip through the supermarket will find plenty of examples of this phenomenon, some of which border on the absurd. The classic pint of ice cream is now fourteen ounces and shrinking. It won’t be long before they will quietly change the definition of quarter to be 2.5 pints. Only conspiracy theorists will notice the change. It used to be that a pint was a pound the world around, but you can’t even buy a pint of beer without a heroic capitalist pulling shenanigans on you. It’s becoming a game with them.

The libertarian line about the market simply being a place where buyers meets sellers sounds good in the hothouse, but in the real world, left unattended, it becomes a grifters alley, where the honest are preyed upon by the unscrupulous. Just as there is never a cop around when you need one, there is no longer anyone policing the practices of our capitalist overlords. If you want to know why people at the end of the Industrial Revolution were open to the call of communism, stand in the chip aisle of your market.

If you are the sort who likes a sandwich and some chips for his lunch, the one thing you can’t help but notice is the bags of chips have grown larger and more expensive. What used to be fifty cents is now a buck-fifty. The bag is also twice the old size, but inside are fewer chips than in the past. It’s already reached the point where the bag is 80% air and 20% product. If this continues on much longer, the lunch time snack will be a dirigible sent to your office containing one chip. That will be your drone delivery.

What the West is experiencing is something people figured out at the end of the industrial revolution. That is, market capitalism is great, except for the market capitalists. Left unsupervised, they quickly turn into bandits in business attire, coming up with clever ways to rob the public. Another feature of this age is the declining number of independent suppliers. It turns out that a feature of unrestrained market capitalism is the strangling of the market by a handful of powerful suppliers, who exercise hegemonic power.

Of course, what is happening here, in a million little daily transactions, is the monetization of public trust. The office workers grabbing lunch trusted that the participants at their local deli were playing fair. Meanwhile, those clever MBA-toting business men and their brilliant ideas about removing just one more pickle from the jar, are exploiting this trust and skimming a few more pennies from the unwitting customer. This sort of practice is modern coin-clipping, which used to be a capital offense.

At some point, when the rubes notice their sandwich can fit in the palm of their hand and the bag of chips is the size of a hot-air balloon, they lose their naiveté and privately realize they are being scammed. We live in a cynical age, because privately, people are coming to believe nothing is on the level and no grift is too small. That has the effect of codifying deceit as a feature of the market and of society. We are rapidly reaching a point where only a sucker trusts anyone other than his friends and family.

This is why unfettered market capitalism is a cancer on society. It turns morality on its head, justifying the unwillingness of the elite to enforce public morality. It’s why your kid’s phone is full of hardcore pornography. The market has spoken and you’re not against the market, are you? Eventually, there is the “A-HA!” moment, when people discover that their private loathing of the daily grift is shared by a large portion of the population. The preference cascade sets the world on fire and morality returns with a vengeance.

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