FedUpUSA

Archive for August 11th, 2010

The zero interest rate policy (ZIRP) will kill the banks. Falling interest rates help banks by increasing the value of their bond and loan portfolios. This is the well understood inverse relationship between discount rate and present value of a future sum. But you see keeping interest rates at zero does virtually nothing for the banks as rates cannot fall further. There is a short window where ZIRP is a positive but an “extended period” (in Fedspeak) is just slow death for the banks.

During that short period, the banks are still collecting on portfolios constructed when rates were higher but as those higher-yielding assets mature, there is nothing comparable to replace them. We hear constantly how banks can just borrow at zero and invest in Treasuries – pocketing the difference. That would be fine if yields on Treasury debt were not low and falling along with everything else. The other problem is that this simplistic formula assumes that banks’ operating expenses are negligible. Both unstated assumptions fail any sort of reality check.

Back in the real world, T-bills yield virtually nothing. The 2-year note is now at 50 basis points as of today. The 5-year is at 1.43% and the 10-year at 2.68%. Assuming zero borrowing cost (which is overly generous), net interest is equal to gross interest. Large banks generally require a net interest spread of more than 2% to cover their expenses, so they will lose money even buying 5-year Treasuries. If they invest their entire portfolio in 10-year notes, they’ll make about a 50 basis point spread on assets pre-tax. But the 10 years is a lot of risk in terms of time for rates to change and also a long time to tie up the money. And banks care BARELY eke out a profit by taking this extreme level of maturity risk. There is a reason why you never see loan portfolios with 10 year average maturities.

For those advocates who think banks can rebuild their balance sheets by buying Treasuries, you might ultimately be correct but there are so many things that can go wrong with that scenario. First consider the size of the hole in bank balance sheets. Recent activity at the FDIC suggests that many troubled banks are overstating the value of their assets by 30% or more – that is the average size of the hit when the FDIC takes them over. At a rebuild rate of 50 basis points annually (with a lot of risk) it would take a literal lifetime to repair the balance sheets via this strategy. It was much easier in the early 1990s when rates for the 10-year started at 9% and never went below 5.5%. There was plenty of room to generate capital gains on bank bond portfolios wit falling rates and still leave a reasonable current yield at the end. Anybody using that era as a template for bank recovery is going to be sorely disappointed. Does anybody still wonder why Japan is trapped despite 20 years of ZIRP?

All of this assumes that ZIRP is sustainable over decades and that the financial system is sufficiently stable to endure the pressure over the long term. Neither one is proven and the ability to fund the debt implied by ZIRP is particularly shaky. If it works, it will take 60 years As one one of our favorite bloggers Karl Denninger says “the math is never wrong.”

JengaFinance

At a time when workers’ pay and benefits have stagnated, federal employees’ average compensation has grown to more than double what private sector workers earn, a USA TODAY analysis finds.Federal workers have been awarded bigger average pay and benefit increases than private employees for nine years in a row. The compensation gap between federal and private workers has doubled in the past decade.

Federal civil servants earned average pay and benefits of $123,049 in 2009 while private workers made $61,051 in total compensation, according to the Bureau of Economic Analysis. The data are the latest available.

The federal compensation advantage has grown from $30,415 in 2000 to $61,998 last year.

Public employee unions say the compensation gap reflects the increasingly high level of skill and education required for most federal jobs and the government contracting out lower-paid jobs to the private sector in recent years.

“The data are not useful for a direct public-private pay comparison,” says Colleen Kelley, president of the National Treasury Employees Union.

Chris Edwards, a budget analyst at the libertarian Cato Institute, thinks otherwise. “Can’t we now all agree that federal workers are overpaid and do something about it?” he asks.

Last week, President Obama ordered a freeze on bonuses for 2,900 political appointees. For the rest of the 2-million-person federal workforce, Obama asked for a 1.4% across-the-board pay hike in 2011, the smallest in more than a decade. Federal workers also would qualify for seniority pay hikes.

Congressional Republicans want to cancel the across-the-board increase in 2011, which would save $2.2 billion.

“Americans are fed up with public employee pay scales far exceeding that in the private sector,” says Rep. Eric Cantor, R-Va., the second-ranking Republican in the House.

Sen. Ted Kaufman, D-Del., says a pay freeze would unfairly scapegoat federal workers without addressing real budget problems.

What the data show:

•Benefits. Federal workers received average benefits worth $41,791 in 2009. Most of this was the government’s contribution to pensions. Employees contributed an additional $10,569.

•Pay. The average federal salary has grown 33% faster than inflation since 2000. USA TODAY reported in March that the federal government pays an average of 20% more than private firms for comparable occupations. The analysis did not consider differences in experience and education.

•Total compensation. Federal compensation has grown 36.9% since 2000 after adjusting for inflation, compared with 8.8% for private workers.

 By Dennis Cauchon, USA TODAY

The following is an absolutely outstanding analysis by Stoneleigh over at Automatic Earth of what the world currently faces. The true threat is monetary deflation. This has been FedUpUSA’s position from the beginning. Prices are always a lagging indictor and price inflation is merely a delayed expression of monetary phenomena. Our real wages have been stagnant for years and are now falling. Home prices have been far out of the affordability range in comparison to wages for almost a decade. Until prices and wages have found equilibrium, we will continue in an economic downward spiral. All the central banks’ interventionist efforts merely keep prices out of reach for businesses and consumers, resulting in the destruction of the real economy (that which produces and that does NOT include government since they do NOT produce), and further serve to strip wealth from the citzenry and transfer it to the governments. In our opinion, this is probably the single-most important article on the economy for the public to read and understand.

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Harris & Ewing Big Dig April 1918
“Downtown construction, Washington, D.C.”

Stoneleigh: There’s an interesting interview at The Energy Report with John Williams of Shadow Stats ( John Williams: Times That Try Our Souls ), which I wanted to discuss because, while there are many aspects are we would agree with, there are other glaring differences with how The Automatic Earth sees the future unfold. It is worth looking at the article in some depth in order to find the source of the disparities.

Mr Williams’ prediction is hyperinflation, although, like us, he is predicting a great depression. One major distinction between TAE’s view and that of many inflationists is the definition of inflation. It is clear from the interview that Mr. Williams’ definition is increasing prices. Readers of TAE will know that our definition is a monetary one – an increase in the supply of money, credit and velocity thereof relative to available goods and services. We have consistently pointed out that using a price definition of inflation removes all the explanatory and predictive value from the concept. Prices changes are lagging indicators of changes in the money supply, complicated by other factors, both globally and locally. For instance, global wage arbitrage has been a major factor driving prices down in recent years, despite a tremendous credit expansion.

Prices do not tell a story by themselves. It is necessary to assess price drivers in order to understand what is unfolding. It is then necessary to adjust prices for changes in the money supply in order to see what is happening to prices in real terms, as opposed to merely nominal terms. Prices in real terms show what is happening to affordability, as it is not price by itself that matters, but price relative to how much money one has in one’s pocket.

Despite his call for an inflationary future, Mr Williams lays out the case for deflation, as defined in monetary terms:

JW: “If you strangle liquidity you always contract an economy and deliberately or not, liquidity is being strangled, resulting in sharp declines in consumer credit, commercial and industrial loans….. “

“…..We’re still seeing contractions in liquidity, and that’s adjusted for inflation. In real terms, M3 money supply is down almost 8% year-over-year.”

 

Williams also points out that the actions of the FED so far are not having an inflationary effect:

“The banks are not lending. The money the Fed put into the system in terms of buying mortgage-backed securities from the banks and trying to help bank liquidity ended up back with the Fed as excess reserves. We have well over $1 trillion there; had the banks loaned that money in the normal stream of commerce, it would have added more than $10 trillion to the broad money supply, which otherwise is up around $14 trillion. That certainly would have had some inflationary impact if not in terms of actual business activity. You can’t always get the economy to grow by pushing money into it. Sometimes it’s like pushing on a string.

It is indeed pushing on a string. Trying to stuff more credit into a system that is already choking on it will do nothing to increase the money supply in circulation. It cannot -even possibly- be inflationary. We are already in monetary contraction, as Williams has noted, and the contraction of credit makes the situation considerably worse than it appears from traditional money supply measures. Contraction is being aggravated by a fall in the velocity of money, as people, companies and banks hang on to what cash they have.

In a deflation, real interest rates are always higher than nominal rates. The real rate is the nominal rate minus inflation, and when inflation is negative, the numbers are added rather than subtracted. Even zero in nominal terms is not low enough to make the real rate sufficiently low to reignite borrowing and lending.

This is the liquidity trap, and governments are thoroughly caught in it already.

There is no chance that the money injected by the Fed will find its way into the real economy, and no chance that it will ignite a wage/price spiral in an era of credit contraction and rising unemployment. Employees will have no pricing power at all under such circumstances, which means that wages will fall rather than rise. Prices will also fall, as the withdrawal of credit will remove price support across the board. However, even as prices fall, affordability will be getting worse, because purchasing power will be falling faster than price.

People typically understand that inflation can make things less affordable over time, but deflation can do so much more quickly and much more comprehensively. The scenario that Williams describes is one of the effects of deflation, with real prices shooting up and everything becoming dramatically less affordable in a very short space of time.

We agree with Williams as to the prospects for the real economy in the near term:

“I expect an accelerating pace of downturn in the next couple of months. The numbers will turn sharply worse….

….By then we’ll find the consensus pretty much in the camp that we’re in a double-dip recession. The popular press will describe it as a double dip, but we never had a recovery. Actually, this is just a very protracted, very deep downturn that has had a pattern of falling off a cliff, bottoming out, having a little bit of bump due to stimulus and then turning down again. Sort of shaped like the path of a novice skier going down a jump for the first time. Speeding sharply down the hill, he goes up in the air and starts spinning wildly as he tries to figure out which end is up with his skis. Then he takes a pretty bad tumble. We’re beginning to spin in the air.”

 

We also agree with Williams as to the nature of the problem – credit expansion – and his observation that credit availability is decreasing:

“Most of the growth we’d seen in the last decade prior to this downturn was due to debt expansion. The debt structures have pretty much been put through the wringer and consumers are not expanding credit, generally because it’s not available to them. Absent debt expansion and/or significant growth in income, no way can the consumer expand personal consumption.”

Without the ability to expand consumption, there is no price support even at current levels, let alone a chance for prices to rise. Credit expansions are based on Ponzi dynamics – the creation of multiple and mutually exclusive claims to the same pieces of underlying real wealth pie, as opposed to cutting the pie into a larger number of smaller pieces as currency inflation would do. The Ponzi nature of credit expansion is the determining factor in the ultimate fate of all bubbles.

Like many inflationists, Williams describes a deflationary scenario, but then says that governments will simply print currency:

“But in this crazy, almost perverse circumstance, the renewed weakness to a large extent will help push us into higher inflation….The only option left going forward is for the government eventually to print the money for the obligations it cannot otherwise cover, which sets up a hyperinflation.”

This projection does not recognize the power of the bond market, which is much greater than that of governments. Any government attempting to print actual currency is going to find that the bond market sends its interest rates through the roof in very short order.

Governments do not set interest rates.

They merely choose a rate to defend. If that rate is radically different from what the bond market thinks appropriate, then the government will bankrupt itself very quickly.

If the bond markets raise interest rates even marginally, while so many governments are very vulnerable to any increase at all, the result will be a tsunami of debt default, which is deflation by definition.

Again, as with most inflationists, Williams supposes that governments have the power to prevent extremely negative outcomes:

“Irrespective of the politics of big government spending, quantitative easing, renewed bailing out of banks, whatever is involved, I’d argue that the government still will do whatever it takes to prevent a systemic collapse….

….The federal government isn’t going to let California or New York or Illinois collapse. Those are threats to the systemic survival. They’re also going to spend a lot more to support people on unemployment.”

 

Governments do not have the power that people imagine them to have. They cannot overcome the power of the collective, when that power is focused like a laser beam in one direction. Governments are going to find that the number of claims on their resources skyrockets, even as their tax receipts fall dramatically and their ability to borrow is curtailed by rising interest rates as a reflection of rising sovereign debt risk. Debt-junkie governments will be caught in a liquidity trap until the power of the international debt financing model is finally broken, as it will eventually be.

However, this does not happen overnight. Until it does, the power of governments to print will be sharply limited. We would expect this to remain the case through the era of deleveraging, which should last for several years. While inflation may be a long term threat once the power of the bond market is broken, that threat lies much further down the line. It is deflation that is today’s threat, and deflation that people must prepare for right now.

We agree with Williams’ diagnosis that a depression is imminent, but not his hyperinflationary rationale for it:

“I’ve been talking about an economic recession, but we are headed for something far worse. I define a depression as a 10% peak-to-trough contraction in the economy. In terms of the broad economy, we’re not down 10% in GDP yet. So while we’re not formally in depression, we’re certainly seeing it in a number of indicators and I think we’ll be in a depression, with GDP down 10%, in the near future.

A contraction greater than 25% peak-to-trough puts you in a great depression. That is what I envision, but we’ll be taken there by hyperinflation and a resultant cessation of normal commerce.”

 

Wiliams has a very different view than The Automatic Earth has of the relatively near-term prospects for the US dollar:

“We’re getting extraordinary protestations from other central banks about the U.S. finances, its solvency, risk of the dollar. Before the current crisis you never would have heard any central banker making such comments. As this breaks, it’s going to be obvious that the U.S. is moving to debase its dollar.

It’ll have no option to do otherwise. I would fully expect some foreign holders looking to dump the Treasuries. With the dollar plunging, the Treasury won’t be able to get the funding that it needs from a practical standpoint in the open markets.

The Fed will come in to salvage that situation, becoming the lender of last resort to the Treasury—literally monetizing the Treasury debt. The Fed might have a couple different ways to address the dollar situation, from raising interest rates to direct intervention, slapping on currency controls. I can’t tell you exactly how it’s going to go. But you’ll have an environment that’s effectively creating a perfect storm for the U.S. dollar.”

The Automatic Earth says that the value of the dollar will increase sharply in the short term – over the next year or two – on a combination of a knee-jerk flight to safety into the global reserve currency and the deflation of dollar denominated debt. Both of these factors will create a demand for dollars, which should act to increase their value relative to other currencies for a period of time. We are not arguing that the dollar is a long term bet – far from it in fact. All fiat currencies eventually die, but now is not that time.

We have argued that people need to hold liquidity during the period of deleveraging, as the risks to cash will be lower than most other wealth preservation strategies. At the point when they can afford to do so without debt, which will depend on how much money they have to begin with, they need to move into hard goods. In doing so, they will prepare for an eventual bottom, at which point inflation should be a genuine threat. People need to be fully liquid at tops and fully invested (in hard goods in this case) at bottoms. In doing so they will be doing the exact opposite of the larger human herd, which is always the best prescription for success.

Williams holds a commonly-held view of the direction of oil prices, and their ‘inflationary’ impact (in price terms):

“Heavy dollar selling will be exceptionally inflationary. Oil prices will spike in response to the weakness in the dollar. Oil is a primary commodity that drives consumer inflation; that’s how you can have inflation in a recession. The traditional wisdom is that strong demand against limited supply causes inflation, but you can also have inflation due to commodity price distortions, which is what we had back in ’73 and what we’ve seen over the last year or so.”

This is at odds with The Automatic Earth’s view of where oil prices are heading in the short term. Our prediction is that falling demand (where demand is not what one wants, but what one can pay for) will lead to falling prices, but that more rapidly falling purchasing power (due to the collapse of the credit that represents over 95% of the money supply) will ensure that lower future prices will be less affordable than higher current ones.

We are predicting lower prices for oil initially, but are expecting demand collapse to set up a supply collapse down the road due to lack of investment in exploration, development and maintenance of existing infrastructure.

The financial crisis thus takes the pressure off in energy terms initially, at the cost of aggravating energy crises significantly in the longer term. Supply collapse will lead to skyrocketing prices in an era of tight money, when most people have very little purchasing power. It will also greatly increase the odds of a resource grab by governments seeking the ultimate source of liquid hegemonic power. Oil can be expected to lose fungibility, and ordinary people may be priced out of the market for fossil fuels entirely.

Williams offers a prescription for preparation that we would take issue with in a number of important respects:

“Hold some gold, silver, precious metals. I’m talking physical possession. Preferably coins because coins, sovereign coins, are recognized as such. They don’t have liquidity issues. Having some assets outside the U.S., and certainly some assets outside the U.S. dollar, is a good thing. I like the Australian dollar, the Canadian dollar, the Swiss franc in particular. They won’t suffer the same hyperinflation in Australia, Canada and Switzerland as we do in the U.S., so those currencies will tend to act as ways of preserving wealth. Over time real estate is a traditional store of wealth, but it’s not portable and sometimes it’s not liquid.”

While (physical) precious metals have been money for thousands of years, and can be expected to hold their value over the long term, they are not ideal for those who are not exceptionally wealthy, i.e. those who can sit on them for perhaps 20 years without having to rely on the value they represent.

Those who would be forced to sell – into the ultimate buyers market of the coming years of deleveraging – would have been better off holding the cash that most will be seeking in the not too distant future.

Governments are very likely to seek to control assets as valuable as precious metals, as they did during the depression. Ownership could be banned and precious metals could be confiscated. It can be as challenging being too close to a source of great value as it is being too close to the centre of power in difficult times. It can mean constantly having to watch your back and never being able to trust anyone. Our view at TAE is that there are many things you could own which will serve you much better than precious metals.

We would agree with Williams’ suggestion as to what kind of supplies to hold in order to have some control over the essentials of your own existence:

Most importantly, build up a store of supplies, more than you would normally consume over a couple of months, particularly food and water, canned goods. Having those goods can save your life in a number of ways. You’d have food to eat, and if you have extra you can use it to barter.

I met a guy who’d been through hyperinflation and found for purposes of the barter system those airline-size bottles of high-quality scotch proved quite valuable. Buy things that you would otherwise consume and rotate your inventory. Don’t go out buying all sorts of things you’ll never use. Keep what makes sense to you and your circumstances. Make sure you have things that are stable. Not too perishable.

 

While he suggests this as a hedge against inflation, we suggest it as a hedge against general economic disruption. Deflation is very likely to lead to a collapse of global trade, as letters of credit dry up and protectionism leads to retaliation-inspiring and -inspired import tariffs and trade wars. As we have a trade system built on long and vulnerable just-in-time supply lines, supply disruption under such circumstances is very likely. Holding one’s own supplies of certain goods, along with liquidity, is therefore a good idea.

We have a great deal of respect for John Williams and what he has achieved with Shadow Stats, but it is always important to assess the foundation of people’s predictions. Williams does not appear to accord sufficient significance to the role of credit and the effect of its evaporation during a Ponzi implosion. He also, in our view, chronically over-estimates the power of governments to control the way that events unfold. Outcomes are possible, indeed probable, that no one would choose. We simply do not have that choice to make. We will be at the mercy of the underlying logic of the system we have built during the expansion years, and that logic leads directly to a deflationary depression.

The AutomaticEarth

Tyler Durden over at ZeroHedge presents Exhibit A: How the financial system buys Congress.  If this chart doesn’t tell it all, I don’t know what does.  When it became exceedingly clear that the large majority of the American public was disgusted with the socialist policies being rammed through Congress and down our throats, Wall Street began to back what they knew to be the winning horse.  Wall Street has an uncanny proclivity for picking the eventual majority in Congress – or do they?  More like, as is their business acumen, they always want to place their bets on the most likely outcome, positioning themselves to ingratiate the winner to them for the entirety of the upcoming tenure.  This is how it is done folks – this is how those that control the money, control Congress and ultimately, retain the power.  Fascism = Socialism with Shareholders.  Please pay attention.

According to the most recent study by the Center for Responsive Politics, Wall Street has completely given up on Democrats, even as contributions to Republicans have surged to a near multi-year record, or 68% of total. After donations hit parity in December 2009, following a gradual decline from a record Democrat preference in March of 2009, the spread between Wall Street charity to Democrats and Republicans has hit nearly 40% in the GOP’s favor. Per OpenSecrets: “The Center’s preliminary study indicates that political action committees and individuals associated with the broad finance, insurance and real estate sector have given more money to federal-level Republican interests during every month since December. The gap continued to grow during that time, reaching its widest point in June.”  The sad conclusion for the Obama administration is that even those who the president burned so much political capital to bail out, and will almost certainly cost him his second term, have turned against him: “But at this juncture, the general trend is clear: The broad financial sector in June appears to have spent a greater percentage of its cash on federal-level Republicans than at any time since May 2008.” (Click Chart For Larger Image)

More from OpenSecrets:

The Center’s preliminary study indicates that political action committees and individuals associated with the broad finance, insurance and real estate sector  have given more money to federal-level Republican interests during every month since December. The gap continued to grow during that time, reaching its widest point in June.

Such a shift away from Democratic candidates — darlings of Wall Street interests for much of 2009 — coincides with Democrat-driven financial reform legislation that President Barack Obama signed last month.

Contribution trends toward Republicans is particularly pronounced in the securities and investment industry, the Center finds.

During March 2009, people and PACs associated with this industry directed 70 percent of their federal-level contributions to Democratic candidates, party committees and leadership PACs.

By June, such numbers had practically flipped, with preliminary figures indicating Republican interests had received 68 percent of all federal-level contributions from this industry.

Individuals associated with these industries, such as company executives and middle managers, are the primary drivers of a Republican campaign donation shift, the Center’s research indicates.

For example, in June, political action committees sponsored by securities and investment firms and trade groups almost evenly split their federal-level political contributions between Democrats and Republicans, preliminary figures show.

But individuals working within this industry favored Republicans by a nearly seven-to-10 margin in June. That’s a significant departure from the beginning of 2009, when individuals working in this industry favored Democratic interests with six dollars for every 10 dollars spent on federal-level political interests.

One may wonder who the two remaining advisors that Obama has surrounded himself by, Larry Summers, and Tim Geithner truly work for: it is no secret that their long-term allegiances lie with precisely those who have now deserted the president. Perhaps it is not too late for Obama to make a clean break with Wall Street and truly embrace the bulk of America’s population in one last act of expiation. After all, that would be a return to precisely the same roots of “change” that got the president elected in the first place. We are confident the American public can fina way to forgive and forget if Obama is truly repentful for the past two years of consistent faux pas.

ZeroHedge