Explaining Modern Finance and Economics Using Booze and Broke Alcoholics

Courtesy of reszatonline, who brings us the following allegory by way of Tim Coldwell, we are happy to distill (no pun intended) all of modern economics and finance in a narrative that is 500 words long, and involved booze and broke alcoholics: in other words everyone should be able to understand the underlying message. And while the immediate application of this allegory is to explain events in Europe, it succeeds in capturing all the moving pieces of modern finance.

From reszatonline

Helga is the proprietor of a bar.

She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar.

To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

Helga keeps track of the drinks consumed on a ledger (thereby granting the customers’ loans).

Word gets around about Helga’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Helga’s bar. Soon she has the largest sales volume for any bar in town.

By providing her customers freedom from immediate payment demands, Helga gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Helga’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Helga’s borrowing limit.

He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral!!!

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS.These “securities” then are bundled and traded on international securities markets.

Naive investors don’t really understand that the securities being sold to them as “AA” “Secured Bonds” really are debts of unemployed alcoholics.

Nevertheless, the bond prices continuously climb!!!, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Helga’s bar.

He so informs Helga.

Helga then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts.

Since Helga cannot fulfil her loan obligations she is forced into bankruptcy.

The bar closes and Helga’s 11 employees lose their jobs.

Overnight, DRINKBOND prices drop by 90%. The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Helga’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds.

Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers. Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multibillion dollar no-strings attached cash infusion from the government.

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Helga’s bar.

Taxpayers Lose Another $118.5 Million As Next Obama Stimulus Pet Project Files For Bankruptcy

Taxpayers Lose Another $118.5 Million As Next Obama Stimulus Pet Project Files For Bankruptcy
Submitted by Tyler Durden on 01/26/2012 12:50 -0500

Remember that one keyword that oddly enough never made it’s way into the president’s largely recycled SOTU address – “Solyndra”? It is about to make a double or nothing repeat appearance, now that Ener1, another company that was backed by Obama, this time a electric car battery-maker, has filed for bankruptcy. Net result: taxpayers lose $118.5 million. The irony is that while Solyndra may have been missing from the SOTU, Ener1 made an indirect appearance: “In three years, our partnership with the private sector has already positioned America to be the world’s leading manufacturer of high-tech batteries.” Uh, no. Actually, the correct phrasing is: “…positioned America to be the world’s leading manufacturer of insolvent, bloated subsidized entities that are proof central planning at any level does not work but we can keep doing the same idiocy over and over hoping the final result will actually be different eventually.” We can’t wait to find out just which of Obama’s handlers was may have been responsible for this latest gross capital misallocation. In the meantime, the 1,700 jobs “created” with the fake creation of Ener1, have just been lost.

From The Hill:

An Indiana-based energy-storage company that received a $118.5 million stimulus grant from the Energy Department filed for bankruptcy Thursday.

Ener1 is asking a federal bankruptcy court in New York to approve a plan to restructure the company’s debt and infuse $81 million in equity funding.

“This was a difficult, but necessary, decision for our company,” Ener1 CEO Alex Sorokin said in a news release. “We are extremely pleased to have the strong support of our primary investors and lenders to substantially reduce the company’s debt.”

The Energy Department in 2009 approved a $118.5 million stimulus grant for EnerDel, a subsidiary of the company that develops lithium-ion batteries used in electric vehicles. The grant was part of a broader program aimed at promoting the development of electric-vehicle battery technology.

At the time, EnerDel said the grant would help the company double its production capacity and create 1,700 jobs. But the company has faced major financial problems in recent months.

Ener1’s decision to file for bankruptcy will likely draw the attention of House Republicans, who are investigating the bankruptcy of Solyndra, the solar panel maker that received a $535 million Energy Department loan guarantee in 2009.
We are extremely confident that the company’s primary investors and lenders are also delighted to have just wiped out $120 million in costless equity value and to have complete control over the company at this point.

And some hilarious selections from the company’s then proud announcement of procuring US taxpayer funding that as of today is no more:

The White House today announced that Indiana-based automotive lithium-ion battery maker EnerDel, Inc., will receive $118.5 million in federal grant funding under the stimulus package passed last spring. The funds will help double the company’s U.S. production capacity, creating approximately 1,700 new jobs in the state. Word came in separate speeches by President Obama in Elkhart, Indiana, and Vice President Joe Biden in Detroit, Michigan.

EnerDel, the lithium-ion battery subsidiary of Ener1, Inc. (Nasdaq: HEV – News), is one of nine companies selected to receive funds for cell, battery and materials manufacturing grants in a broadly subscribed solicitation managed by the U.S. Department of Energy (DOE). EnerDel received the full amount it requested. In all, 48 companies in the electric and hybrid vehicle sector received a total of $2.4 billion in awards today.

“This is about planting the roots of a critical industry firmly in American soil,” said Ener1 Chairman and CEO Charles Gassenheimer. “The economic benefits associated with this government investment will stretch far beyond the battery industry. Carmakers in North America, foreign and domestic, are counting on advanced battery systems to power an entire new generation of electric and plug-in hybrid vehicles.”

The grants will work together with the applied for long-term, low-interest loans under DOE’s Advanced Technology Vehicle Manufacturing program (ATVM), in unleashing private capital flows to companies in this sector. EnerDel is in advanced stages of discussions with DOE regarding its ATVM application.

“These government incentives will provide a powerful stimulus to a vital industry and help ensure that the batteries eventually powering millions of cars around the world carry the stamp ‘Made in the USA,’ Gassenheimer said.

EnerDel is the first and so far only company in the industry to have built facilities in the United States to produce automotive lithium-ion batteries on a commercial scale, and recently unveiled one of the most advanced battery cell production lines in the world at its plant in Indiana. The company also recently announced partnership projects with Volvo and Nissan, as well as with plug-in and electric vehicle makers Fisker and Think Global.

“We are in a race today that will decide who will make the technology to power future generations of fuel-efficient vehicles around the world,” said EnerDel CEO Ulrik Grape. “Korea, Japan and China are doing everything they can to win it, but with these new resources, the Obama administration is helping America’s best, most innovative players move ahead of the pack.”

“Economic growth is not a Democratic or Republican issue. This effort has been a model of bi-partisan cooperation by Senators Richard Lugar and Evan Bayh, and by Governor Mitch Daniels,” Grape said. “Their support has been tremendously important.”

The funds will help EnerDel in mass producing a high-quality automotive product with a wide range of engineering capabilities for multiple automotive requirements, including high-speed, automated production lines for cell electrode manufacturing, and lean-manufacturing techniques for battery assembly.
Good work US taxpayer – through your selfless loss of money you have managed to splatter yet another egg of infinite humiliation on the fact of the world’s biggest and most incompetent central planning administration, which would make even Stalin green with envy.

And, heeeeeere’s Joe Biden. One wonders if his favorite advisors Jon Corzine was responsible for this brilliant investment idea.

At least the propaganda video has dramatic music. How much did that cost taxpayers?

Is the United States in a Liquidity Trap?

Is the United States in a Liquidity Trap?

In his New York Times article of January 11, 2012, the Nobel laureate Paul Krugman wrote,

If nothing else, we’ve learned that the liquidity trap is neither a figment of our imaginations nor something that only happens in Japan; it’s a very real threat, and if and when it ends we should nonetheless be guarding against its return — which means that there’s a very strong case both for a higher inflation target, and for aggressive policy when unemployment is high at low inflation.

The bottom line is that the Fed almost surely won’t, and very surely shouldn’t, start raising interest rates any time soon.

But does it make sense that by means of more inflation the US economy could be pulled out of the liquidity trap?

The Origin of the Liquidity-Trap Concept

In the popular framework of thinking that originates from the writings of John Maynard Keynes, economic activity is presented in terms of a circular flow of money. Thus, spending by one individual becomes part of the earnings of another individual, and spending by another individual becomes part of the first individual’s earnings.

Recessions, according to Keynes, are a response to the fact that consumers — for some psychological reasons — have decided to cut down on their expenditure and raise their savings.

For instance, if for some reason people have become less confident about the future, they will cut back on their outlays and hoard more money. So, once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

Consequently, a vicious circle sets in: the decline in people’s confidence causes them to spend less and to hoard more money, and this lowers economic activity further, thereby causing people to hoard more, etc.

Following this logic, in order to prevent a recession from getting out of hand, the central bank must lift the money supply and aggressively lower interest rates.

Once consumers have more money in their pockets, their confidence will increase, and they will start spending again, thereby reestablishing the circular flow of money, so it is held.

In his writings, however, Keynes suggested that a situation could emerge when an aggressive lowering of interest rates by the central bank would bring rates to a level from which they would not fall further.

This, according to Keynes, could occur because people might adopt a view that interest rates have bottomed out and that rates should subsequently rise, leading to capital losses on bond holdings. As a result, people’s demand for money will become extremely high, implying that people would hoard money and refuse to spend it no matter how much the central bank tries to expand the money supply.

Keynes wrote,

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. [1]

Keynes suggested that, once a low-interest-rate policy becomes ineffective, authorities should step in and spend. The spending can be on all sorts of projects — what matters here is that a lot of money must be pumped, which is expected to boost consumers’ confidence. With a higher level of confidence, consumers will lower their savings and raise their expenditure, thereby reestablishing the circular flow of money.

Do Individuals Save Money?

In the Keynesian framework the ever-expanding monetary flow is the key to economic prosperity. What drives economic growth is monetary expenditure. When people spend more of their money, this is seen that they save less.

Conversely, when people reduce their monetary spending in the Keynesian framework, this is viewed that they save more. Observe that in the popular — i.e., Keynesian — way of thinking, savings is bad news for the economy: the more people save, the worse things become. (The liquidity trap comes from too much saving and the lack of spending, so it is held.)

Now, contrary to popular thinking, individuals don’t save money as such. The chief role of money is as a medium of exchange. Also, note that people don’t pay with money but rather with goods and services that they have produced.

For instance, a baker pays for shoes by means of the bread he produced, while the shoemaker pays for the bread by means of the shoes he made. When the baker exchanges his money for shoes, he has already paid for the shoes, so to speak, with the bread that he produced prior to this exchange. Again, money is just employed to exchange goods and services.

To suggest then that people could have an unlimited demand for money (hoarding money) that supposedly leads to a liquidity trap, as popular thinking has it, would imply that no one would be exchanging goods.

Obviously, this is not a realistic proposition, given the fact that people require goods to support their lives and well-being. (Please note: people demand money not to accumulate indefinitely but to employ in exchange at some more or less definite point in the future).

Being the medium of exchange, money can only assist in exchanging the goods of one producer for the goods of another producer. The state of the demand for money cannot alter the amount of goods produced, that is, it cannot alter the so-called real economic growth. Likewise a change in the supply of money doesn’t have any power to grow the real economy.

Contrary to popular thinking we suggest that a liquidity trap does not emerge in response to consumers’ massive increases in the demand for money but comes as a result of very loose monetary policies, which inflict severe damage to the pool of real savings.

Liquidity Trap and the Shrinking Pool of Real Savings

As long as the rate of growth of the pool of real savings stays positive, this can continue to sustain productive and nonproductive activities. Trouble erupts, however, when, on account of loose monetary and fiscal policies, a structure of production emerges that ties up much more consumer goods than the amount it releases. This excessive consumption relative to the production of consumer goods leads to a decline in the pool of real savings.

This in turn weakens the support for economic activities, resulting in the economy plunging into a slump. (The shrinking pool of real savings exposes the commonly accepted fallacy that the loose monetary policy of the central bank can grow the economy.)

Needless to say, once the economy falls into a recession because of a falling pool of real saving, any government or central-bank attempts to revive the economy must fail.


Not only will these attempts not revive the economy; they will deplete the pool of real savings further, thereby prolonging the economic slump.

Likewise any policy that forces banks to expand lending “out of thin air” will further damage the pool and will reduce further banks’ ability to lend.

The essence of lending is real savings and not money as such. It is real savings that imposes restrictions on banks’ ability to lend. (Money is just the medium of exchange, which facilitates real savings.)

Note that without an expanding pool of real savings any expansion of bank lending is going to lift banks’ nonperforming assets.

Contrary to Krugman, we suggest that the US economy is trapped, not because of a sharp increase in the demand for money, but because loose monetary policies have depleted the pool of real savings. What is required to fix the economy is not to generate more inflation but the exact opposite. Setting a higher inflation target, as suggested by Krugman, will only weaken the pool of real savings further and will guarantee that the economy will stay in a depressed state for a prolonged time.


[1] John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan & Co. Ltd. (1964), p. 207.

Price versus Volume

Here is a chart of apparel trends sent to me last week by reader Tim Wallace.


As I have been saying over the past several months there is a tremendous unit drop going on in the import apparel industry, but it is not reflected in reporting because dollars keep going up, at least until recently when they flat-lined.

The attached chart looks at the two criteria together, dollars imported and units imported reflected as meters square. As you can see, the dollars kept going up but the units turned south back in May, yes the very May my petroleum distillates distinctly show the economy turning south.

Things are just starting south like towards the end of 2007. Give it time.

Demand is plummeting.
JC Penney’s Slashes Prices on All Merchandise by “At Least 40%”

I had forgotten about the apparel chart from Wallace but was reminded of it today by this headline news story today in USA Today: Penney’s slashing prices on all merchandise


The Fed Should Hire A Mechanic

The “Transmission Mechanism” Is Broken.

Peter Tchir

As the Fed debates what form of QE to launch on the world and whatever new communication strategies they are going to employ, maybe they should sit back and figure out why their policies seem to be doing so little.

The Fed is clearly trying to stimulate the economy. As much as I disagree with many of their policies, I do believe their intentions were to boost the economy and not just help banks make easy money. In spite of their intentions, they have failed and I think it is because they are clinging to two flawed assumptions.

The Wealth Effect

The Fed seems to have an unwavering belief in the wealth effect. They believe that if they can just increase stock prices, people will feel better and spend more. This may have been the case at one time, but there are several reasons why it isn’t working. The most obvious flaw (which has been reported on www.zerohedge.com) is that the wealth is now far too concentrated to benefit the economy as a whole. Relatively few people own most of the shares. The benefit of an increasing stock market just goes to too few people. We are just off record highs of food stamp recipients, but the number is shocking. Somewhere around 45 million people are getting food stamps. It doesn’t take a PhD in economics to figure out that people using food stamps to survive are unlikely to get too excited about stocks being up 15% or even 30%.

So the poor don’t care about the wealth effect.

What about the middle class? Maybe in 2000 people would have been impressed by the wealth effect and spent more, but things have changed. The middle class is worried about their homes. They are not comfortable that they have much equity (if any) in their homes and that has created risk aversion that will outweigh any wealth effect. But the wealth effect is further eroded since much of the “savings” and stock investments are held in IRA’s. The middle class remains concerned not only about their jobs, but also about what they will be forced to pay for in the future. Even those people lucky enough to have defined benefit plans are concerned that those pensions and benefits will be cut back. The likelihood of receiving significant support from governments in the future (state, local, or federal) is being questioned. So the gains in IRA are offset by fears that other promises will be broken. The wealth effect may allow the middle class to consume at a reasonable level, but there are too many other concerns for this wealth effect to have much of an impact.

What about the rich? Certainly at the extreme end, going from 100 million to 110 million probably doesn’t do much for your ability or willingness to consume. Even at a lower wealth level, the change may not be enough to offset future earnings concerns – especially if you work on Wall Street. The “rich” have a lot of their wealth in restricted shares of their companies. That value will have increased, but the willingness to spend money based on an increased valuation of restricted shares is greatly diminished. Enron was treated as an isolated case, but since 2007, people are being much more careful treating “restricted shares or options” as true savings.

Then there is the psychology of the rich. Many of the rich got rich because they were smart or hard working or figure out what someone needed. They made money because they found opportunities and took advantage of those opportunities. They are smart enough to see that this “wealth effect” is being created by artificial stimulus and not real true demand. The Fed is creating demand for “risk assets” but not for products. The rich will find ways to accumulate and sell “risk assets” because that is where the Fed has been able to stimulate demand. That doesn’t generate longer term growth for the economy, but why would the rich spend money to build factories or create new products when the actual demand for products hasn’t changed? They won’t. The fact that the rich know QE just creates demand for risk assets is one of the biggest (and least discussed) reasons for the failure of QE programs to generate growth in the real economy.

At least the Fed does seem to be trying to target housing now. They must realize that attempting to generate “wealth effect” growth via the stock market is hopeless.

Low Rates for Banks means Low Rates for Banks’ Customers

Somehow the Fed believes that providing low cost funds for banks will translate into low cost funds for the clients of the banks. It just isn’t happening. Liquidity remains a key concern of banks. They are willing to sacrifice margin for liquidity and perceived safety. Why lend to a consumer when you can buy corporate bonds or treasuries. Those have much greater liquidity and require much less effort to accumulate a large portfolio then making loans a few hundred thousand dollars at a time.

The Fed has not only underestimated how much value the banks place on liquidity, they have encouraged it, as capital rules benefit banks with more liquid assets. Lending to small companies and individuals requires lots of work (costs) and results in relatively illiquid assets. The banks are placing a high value on liquidity and are extremely cost conscious, so the cheap money they get is not making it down to the lower levels of the economy. Microsoft, on the other hand, can add to their cash stash with one quick call to the syndicate desk at any big bank.

Not only have the regulations encouraged banks to concentrate on liquid assets, the Fed has given them extra reasons to focus on the lowest risk products. By becoming a bid of last resort (as far as I know there have been no details on the prices paid by the Fed for its POMO purchases) the Fed was able to help banks generate easy profits (notice how almost no bank lost money on any day when QE2 was active). Banks focused on the assets where they know there is always a bid, and not exactly the most price sensitive bid. Operation twist has failed to help get cheap mortgages into the average consumer, but it did manage to teach banks that they should continue to stick to assets where there was easy money to be made and where positions could be closed quickly.

These extremely cheap loans were like free money. Somehow the Fed thought bankers would stand in line, take the cheap money and then do something constructive for the economy with it. Instead, the banks take the free money and then do what any intelligent human being would do, they go to the back of the line to get more free money.

When a theory doesn’t work, it is often because the assumptions are flawed. The Fed should be going back and figuring out how to address the failure of the stock market wealth effect and of the bottleneck of the banks. Maybe the Fed should just make mortgage loans directly to individuals? Probably a stupid idea, but at least it would impact homes which is where the wealth effect would really be felt across the board, and it would ensure the cheap money was making it to the people the Fed wants to see getting cheap money.