Filmed January 19, 2011 near Santa Cruz, Southbound
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?
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.
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. 
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.
 John Maynard Keynes, The General Theory of Employment, Interest, and Money, MacMillan & Co. Ltd. (1964), p. 207.
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 “Transmission Mechanism” Is Broken.
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.
Economists: A Profession at Sea
January 19, 2012 | By Robert Johnson | 14
After the financial crisis of 2008, the Queen of England asked economists, “Why did no one see the credit crunch coming?” Three years later, a group of Harvard undergraduate students walked out of introductory economics and wrote, “Today, we are walking out of your class, Economics 101, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society.”
What has happened? Rebellion from both above and below suggests that economists, who were recently at the core of power and social leadership in our society, are no longer trusted. Not long ago, the principal theories of economics appeared to be the secular religion of society. Today, economics is a discipline in disrepute. It’s as if our ship of state broke from its stable mooring and unexpectedly slammed into the rocks. How could things have gone so spectacularly wrong? And what can be done to repair economics so economists can play a productive role in helping society?
As the Oscar-winning documentary Inside Job illustrated, there is a very lucrative market for false visions of financial-market behavior that legitimate the desires of participants to be unshackled and make more money. But good policy prescriptions are public goods that represent the social good and not just the concentrated financial interests. Unfortunately, as economists beginning with the work of Adam Smith have repeatedly shown, public goods are underprovided in the marketplace. In addition, the reputation of the economics profession is itself a collective good, and those who have tarnished it are not adequately penalized for the damage they do to their fellow professionals when they accept large sums of money in return for marketing a perspective that benefits vested interests.
These are problems that some within economics have been aware of for a long time, but the discipline as a whole has been unable to address them. The onus is on the profession to face these challenges and help lead society off the rocks.
How to Save Economics
first, economists should resist overstating what they actually know. The quest for certainty, as philosopher John Dewey called it in 1929, is a dangerous temptress. In anxious times like the present, experts can gain great favor in society by offering a false resolution of uncertainty. Of course when the falseness is later unmasked as snake oil, the heroic reputation of the expert is shattered. But that tends to happen only after the damage is done.
Second, economists have to recognize the shortcomings of high-powered mathematical models, which are not substitutes for vigilant observation. Nobel laureate Kenneth Arrow saw this danger years ago when he exclaimed, “The math takes on a life of its own because the mathematics pushed toward a tendency to prove theories of mathematical, rather than scientific, interest.”
Financial-market models, for instance, tend to be constructed with building blocks that assume stable and anchored expectations. But the long history of financial crises over the past 200 years belies that notion. As far back as 1921, Frank Knight of the University of Chicago made the useful distinction between measurable risk and “unknown unknowns,” which he called radical uncertainty. Knight’s point was that in a period of radical uncertainty, expectations couldn’t be anchored because they have nothing to latch onto. Financial theories and regulatory designs that hinge on the assumption of stable and anchored expectations are not resilient enough to meet the challenges presented by real financial markets in radically uncertain times.
The third remedy for repairing economics is to reintroduce context. More research on economic history and evidence-based studies are needed to understand the economy and overcome the mechanistic bare-bones models the students at Harvard objected to being taught.
But the economic orthodoxy continues its romance with the Enlightenment tradition of Cartesian “universal laws.” This began after the Thirty Years’ War, when society demanded both a method of investigation that did not antagonize religious factions and universal abstract laws and principles that could be objectively proven. Lost to the traumas of religious and social turmoil were the humble and pragmatic humanistic approaches of Francis Bacon and Michel de Montaigne and the suppleness of William Shakespeare. Reorienting economics away from the Enlightenment glamour of high theory and returning it to focusing on real problems, in the same way a clinical physician does, would make economics more relevant.
The profession needs to realign the incentives for doing reputable research in order to protect its integrity as a whole, as is done in medicine. Recent policies announced by the American Economic Association on disclosing conflicts of interest are a step in a healthy direction. Faculty members should also be forced to step down from consulting at the time they receive tenure.
Fourth, we must acknowledge the intimate, inseparable relationship between politics and economics. Modern debates about who caused the financial crisis—government or the private financial sector—are almost nonsensical. We are living in an era of money politics and large powerful interests that influence the laws and regulations and their enforcement. In order to catalyze the evolution of economics, research teams would benefit from multidisciplinary interaction with politics, psychology, anthropology, sociology and history.
Such interdisciplinary communication would also benefit another neglected area of economics: the study of macroeconomic systems. Psychologists mock what economists call the microfoundations of consumer behavior—a set of assumptions based on the idea that isolated individuals behave with clear knowledge of the future. That this framework is suitable for aggregate systems in a globalized economy simply because the tribe called economics has agreed to adhere to these ad hoc assumptions makes no sense. Increased interactions with disciplines that economists have often mocked as unscientific would greatly improve economists’ understanding of the real world and would be more truly scientific.
Many of these suggestions have been argued within the profession as far back as the formation of the American Economic Association in the late 19th century. Its committee on graduate economics education, a panel created in the early 1990s to take stock of the field, as well as the work of economist David Colander and others, has repeatedly illuminated these concerns with economic method and education. It is only now, with the force of recent events so damaging to societies everywhere on earth, and with the rise of developing countries that see the shortcomings of the economic orthodoxy’s prescriptions, that the resistance to renewing the economics profession may be overcome. Until then, we are really at sea without an anchor.
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
~John Maynard Keynes
This year will mark my 32nd year in the business. I began my career in 1980 after spending several years in corporate life, which I did not find to my liking. I had too much of an independent streak and eventually came to the realization that I’d be much better off starting my own business. When I entered the financial world interest rates were beginning to peak, as the long upward climb in inflation was coming to an end under the leadership of Paul Volker at the Fed. It is hard to believe today that interest rates on treasuries were as high as 15.7%. The yields on money market funds were over 18%. Inflation rates were over 14%, with oil prices at $40 a barrel. Gold and silver would eventually peak at $850 and $50 an ounce, respectively.
Where the Debt Supercycle Begins
I spent my first decade in the business as a broker before transforming my business to a fee-based money management firm. All I sold in the 1980’s was fixed income. Who wanted to invest in stocks when you could get double digit returns in guaranteed deposits at a bank or by investing in government debt? I still remember one of my first trades—a 10-year treasury note paying a 15% interest rate.
What I did not realize at the time was the U.S., and the western world in general, was about to embark on what we now refer to as the “Debt Supercycle”—a theory articulated by the investment strategists at Bank Credit Analyst out of Canada. The Debt Supercycle is a description of the long-term decline in U.S. balance sheet liquidity and the rise in indebtedness during the WWII period. Economic expansions in the post WWII world were associated with the buildup in debt as western governments introduced automatic stabilizers through entitlements such as unemployment benefits, Social Security, Medicare, and deposit insurance at financial institutions. During the early stages of debt buildup, government policies were successful in preventing the frequent depressions that plagued the pre-WWII economy. Western economies would experience periodic corrections during recessions, but these recessions did not reverse the long-term trend of debt buildup that continued to grow with each successive decade.
These trends would lead to growing illiquidity making our financial markets more fragile and susceptible to the threat of a deflationary event like we experienced recently in the great credit crisis of 2008-2009. These periodic recessions were fought by governments with more deficit spending and credit creation. Thus, the bigger balance sheet excesses became, the more painful the eventual corrective process would be. The financial stakes became higher in each new economic cycle, putting ever-increasing pressure on governments to reflate demand, by whatever means were available.
According to the Bank Credit Analyst the Debt Supercycle reached an important inflection point in the recent economic meltdown of 2008-2009. Authorities reached the limit of their ability to get consumers to take on more credit. The result is that it forced governments to leverage up instead. This is where we are today as authorities spend, borrow and print money to fight off the deflationary impact of private sector deleveraging. Welcome to the final chapter of the Debt Supercycle—a period of trillion dollar deficits that are being monetized by trillion dollar expansions of central bank balance sheets, otherwise known as money printing. Once fiscal policy is pushed to the limits of sustainability, the Debt Supercycle will come to a violent end. This is exactly what is happening to Europe now.
A graphic depiction of this Debt Supercycle can be seen below. As of this writing, outstanding U.S. federal debt is close to $15.3 trillion dollars. For the first time in my lifetime US federal debt now exceeds U.S. GDP. In personal terms each U.S. citizen now owes $180,559.1
Our politicians have been acting irresponsibly, paying only lip service to the nation’s rapidly growing debt burden. It has been argued that our debt is not as bad as it appears and we have plenty of options and time to resolve this issue. Some argue for higher taxes, others for dramatic spending cuts. The truth is that neither will work alone. There aren’t enough taxpayers to pay the bill, even if we raise tax rates to 100% on the rich. Spending cuts will also not solve our problems unless we eliminate all forms of entitlements and drastically reduce the size of our military. In the end, our only option will be to pursue a combination of tax increases, entitlement and spending reductions, and a steady dose of inflation. This is the policy we pursued after WWII and it is now the official policy of the U.S. government, a term referred to as financial repression.
“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”
~Friedrich August von Hayek
I would like to address the unusual phenomenon of the Debt Supercycle and why it has gone on for well over three decades without a major crisis until recently. Politicians, and the Keynesian economists who support them, have long argued that debt imbalances don’t matter. What matters is the economy’s ability to grow and it is government’s job to make sure it grows through whatever means necessary. On the surface this argument seems plausible. The two graphs below illustrate the popularity of this view.
From 1978 to today, the U.S was able to grow its total debt from $719 billion to $56 trillion, an annualized growth rate of 13.7%.2 While U.S. debt was growing during this period of time the interest rate paid on that debt steadily declined. This confounded experts who would have predicted higher rates of inflation and certainly higher rates of interest. This can be explained. At the end of the 1970’s inflation rates were hovering over 14%, bond yields on U.S. treasuries had risen to over 15%. The US. Government had been financing its growing deficits by urging the Fed to monetize its debt by printing money to buy U.S. treasuries. This is what led to the rising inflation rates during the 1970’s. This philosophy came to an end with President Carter’s appointment of Paul Volcker to head up the Federal Reserve.
From Printing Presses to the Bond Market
Volcker and other central bankers convinced their respective governments that they could tame the inflation monster by financing deficits through the bond market rather than the current practice of monetizing (printing money to pay off) the debt. Stung by a wave of rising inflation, governments turned to their central banks for advice. The advice given had three components: one, raise short-term interest rates in order to restrain bank borrowing by individuals and businesses; two, cut government borrowing; and three, use the bond market to finance budget deficits by selling bonds to domestic and overseas investors.
It was argued, and rightly so, that when a government taps the bond market it is drawing from the existing stock of savings—no new money is created. Large institutions such as insurance companies, pension funds, mutual funds, and individual investors would supply the necessary capital to finance government deficits. The inducement to supply this capital was high real interest rates, an interest rate that was well above the inflation rate. It worked. The migration of credit expansion from within the monetary sector to outside it was the single biggest reason why OECD government inflation fell below five percent throughout the 80’s, 90’s, and the 2000’s. As shown in the graphs above, it led to rising debt levels and falling interest rates.
Another process that occurred during this period that facilitated government debt financing was the revolution that was occurring in the capital markets. Peter Warburton described this process in his seminal work “Debt and Delusion,” from which I now quote:
The capital markets’ revolution of the late 1980’s and the 1990’s was facilitated by several parallel developments, of which five stand out. First, the incapacity of the banks, due to non-performing loans; second, the adoption of liberal credit policies by governments; third, the displacement of discretionary consumer borrowing by obligatory government borrowing (to finance budget deficits); fourth, the concentration of management of private wealth in the hands of large funds; and fifth, the increased use and acceptance of financial derivatives….
If this powerful shift from traditional bank borrowing towards the capital markets in North America and Western Europe had not taken place, it is most probable that there would have been a much longer period of recession and consolidation in the aftermath of the late 1980’s property bust….
Deprived of the easy option of selling bonds to investment funds and individuals, the government would probably have resorted to greater monetization of their borrowing….
If this traditional course of action had been followed, then there is little doubt that inflationary fires would have been rekindled in the western economies during the 1990’s by pressing additional liquidity (cash and bank deposits) into the hands of consumers and firms, the demand for goods, services and assets would have increased relative to their available supplies. After a couple of years or so, the outcome of excessive money creation would have been a resurgence of consumer price inflation, following the pattern of the 1970’s and early 1980’s.
This process worked for an extended period of time with occasional hiccups and financial failures: the bankruptcy of Orange County, the Mexican peso crisis in late 1994, the collapse of Barings Bank in 1995, the Asian currency crisis in 1997, and the Russian debt default and the bankruptcy of Long Term Capital Management in 1998.
The Rise of Derivatives
Overtime, a new pattern was beginning to emerge by the 1990’s and continues on to this day: an increasing frequency of rogue waves or black swan events.3With the increasing role of large financial institutions as intermediaries within the financial system a large important part of capital transfers were being done in secret through the derivatives market. Transactions between investment banks and mega funds such as hedge funds were increasingly being transacted in secret in the OTC derivatives market far from the public gaze.
Derivatives were the ultimate leverage tool used by hedge funds and the proprietary trading desks of large banks in gearing up the financial system. The use of derivatives enabled these financial entities the ability to gain control of a larger asset portfolio with a smaller commitment of capital. Derivatives in effect gave artificial support to both the bond and equity markets. It also facilitated the massive leveraging of the financial system with debt-to-asset ratios rising from 12-1 to 40-1 by the time of the 2008 financial crisis. Most importantly, the synthetic support given the bond and equity markets by these leveraged instruments were critically dependent on the downward progression of interest rates and the shape of the yield curve. A small tremor in the structure of interest rates would undermine the profitability of these leveraged trades leading to forced selling in the bond, equity, and commodity markets, which explains much of what happened during 2007-2009.
Risk On/Risk Off and the “Paranormal” Market
The fact remains that our financial system still remains highly leveraged. As Bill Gross recently wrote in his 2012 investment outlook, “most developed economies have not, in fact, delevered since 2008…credit as a whole remains resilient or at least static because of a multitude of quantitative easings (QE) in the U.S., U.K., and Japan…and now Euroland countries.”4
Because interest rates are now zero bound, according to Gross, it raises the possibility of a fat left-tailed possibility of unforeseen delevering or the fat right-tailed possibility of central bank inflationary expansion. The result is we face a number of years in the future where economies will exhibit different aspects of the New Normal which Gross describes as “Sub,” ”Ab,” or “Paranormal” (to be explained below).5
The global financial system is still leveraging up. However, this time it is governments that are doing the leveraging. Today, sovereign debt is being issued in copious quantities. The vast majority of this debt is being used to finance non-productive consumption. All of the world’s major governments are spending and living well beyond their means leaving central banks to return once again towards aggressive debt monetization to desperately ensure interest rates remain subdued and the financial system abundantly liquid. As Grant Williams explained with the following image below, “currently the central banks of the top three developed world entities: the Eurozone, the US and Japan have balance sheets that amount to roughly $8 trillion…What does this mean? It means that nearly $8 trillion in world economic growth is artificial and exists only courtesy of central bank intervention…It also means that central banks will never unwind their ‘assets’…It also means that in this age of ongoing consumer and corporate deleveraging, central banks will have no choice but to continue monetizing.”
This creates an unstable dynamic whereby market participants focus their attention on divining opaque and unpredictabie moves by “the powers that be” rather than the real and economic value of various assets. This anticipation by highly leveraged financial players of policy reflation is what underpins the highly speculative nature of our current global marketplace. When reflationary policies are delayed or not forthcoming, the markets deleverage and go into “risk off” mode. This drives the dollar higher and treasury yields lower. When the monetary bazookas are unleashed the “risk on” trade is executed and stocks and commodities rise universally. This “risk on/risk off “ trade is now part of the new Paranormal that Gross describes in his 2012 investment outlook.
When Markets Rebel
The question as to which fat tail risk (left or right) the markets experience boils down to a game of confidence that governments and their respective central banks are playing with the bond markets. The risk to government is that because of zero bound interest rates, governments have been financing a good portion of their debt short-term. The rate of interest is low which helps to reduce deficits. The danger is that since a good majority of debt is short-term it will have to be rolled over. As long as confidence is maintained debt will continue to roll over at existing low interest rates. The real danger is when the markets lose confidence in policymakers. That is, if the markets rebel and demand higher rates of return. It is a rise in interest rates which now directly threatens the solvency of many governments. Record debt levels are not a burden to government as long as interest rates remain low. It is when confidence is lost and rates rise that the solvency issue comes into question. This is the nightmare scenario that keeps central bankers up at night; a warning Sidney Homer wrote in his “A History of Interest Rates”:
Many besides the government have been encouraged to borrow at short who in an earlier age would have borrowed at long term just to be sure the funds would be available if needed. The dangers of this procedure became sadly evident in the 1970’s, when certain borrowers, such as Penn Central and New York City, suddenly found the refunding market closed to them.6
We now live in a new era of uncertainty—Pimco’s new “paranormal,” if you will. Our financial system continues to leverage up as governments replace the private sector in gearing up their balance sheets. Central banks are now embarked on a policy of reflation, monetizing a major portion of rising government deficits. The ECB’s balance sheet expanded by $947B (euro 727B), or 36% last year, to a record $3.5T. The Fed expanded its balance sheet by $513B to $2.92T, an increase of 21%.
We are now at a state where the sovereign bond market has grown to become the largest financial bubble in history; a bubble that could succumb to three potential market shocks. The first type of shock would come from a spike in commodity prices triggered by additional rounds of quantitative easing. It could be as simple as an “act of God” such as an earthquake, tsunami, or the failure of an important agricultural crop. The bond market would react in fear that higher commodity prices would be absorbed in the price of goods and services via loose monetary policy.
A second shock could be triggered as a result of political instability and loss of confidence in government policy. An example is what is occurring right now in Europe regarding an attempt toward a fiscal union or the debt ceiling debate in the U.S. The bond market would view negatively a failure by governments to rein in spending and control their deficits.
The third shock would emanate from a potential default or restructuring of a sovereign debt that would lead to a domino effect in the banking system. A large international bank or group of banks might not be able to meet their obligations which would lead to a rise in fear of uninsurable losses among the banks or their counterparties.
As the bond market continues to expand through sovereign debt expansion and central bank monetization, it is moving further away from reality as a result of speculative activity. This makes sovereign debt extremely sensitive to any unanticipated event. The probability of another black swan or rogue wave is beginning to multiply; from a failed bond auction, to larger than expected deficits, to political rancor over spending cuts. Sovereign debt can no longer be looked upon as a risk free asset. For the reasons cited above I continue to avoid U.S. treasury debt as the rates of return bear no resemblance to reality or are commensurate with the risk they entail. Caveat emptor!