The "New" Liquidity

This is the age of the “New” liquidity.  This new liquidity is driven by two things: first, information technology; and second, by the free flow of capital throughout the world. 

Finance is nothing more than information.  A dollar bill can be exchanged for another dollar bill.  A demand deposit can be exchanged for dollars and is nothing more than 0s and 1s on some bank’s computer.  A bond provides you with a series of cash flows, which are nothing more than electronic blips, 0s and 1s.  Mortgage-backed securities are nothing more than different cash flows cut into streams that suit the needs of whoever buys them…0s and 1s.

Information can be “sliced and diced” any way that you want it and can be stored and transmitted instantaneously almost anywhere in the world.   This latter point is where the free flow of capital throughout the world enters the picture.

This free flow of capital throughout the world is where the “new” liquidity comes in.  Financial assets, in today’s world, are extremely liquid.

 That is, these assets are liquid…until they aren’t liquid!  They remain liquid until something changes, like the price of the real estate behind certain assets ceases to rise continuously. 

And, this is the new world that the Federal Reserve has to operate within. 

The financial innovation of the last fifty years has been truly exceptional.  Information technology has aided this advance.  There are derivative instruments everywhere.  International capital markets have meant that financial assets can be placed all over the world.  The finance industry has become a huge part of the global economy, both in terms of wealth produced and in terms of employment.  Even manufacturing firms like General Motors and General Electric have gotten into the game and in recent years their finance wings have produced a majority of their profits.

The volume of financial assets that have been produced in this environment has relied on the liquidity of international capital markets to facilitate and expand the flow of these assets into every corner of the world.  The ease of the flow has been truly remarkable.

But, it is the very ease of the flow that has created problems here and there.  The problems I am alluding to are called “bubbles.”  Because capital can flow so freely from market to market and this flow can take place almost immediately, capital can move rapidly from various segments of the capital markets into other segments as sentiment or information changes.  And, as long as the markets remain “liquid” the movements can continue until the situation is played out.

This is a different environment from the one that the current model of monetary policy is based upon.  That model, originally created through the Bretton Woods agreement in the 1940s, assumed that there would not be a free flow of capital internationally.  Thus, with a gold standard and fixed exchange rates, the economic policy of a government could be focused on maintaining high levels of employment, low levels of unemployment. 

Of course, the credit inflation of the 1960s destroyed the underlying assumptions of this international monetary agreement and this was institutionalized on August 15, 1971 as President Richard Nixon took the United States off the gold standard and floated the value of the dollar.

The subsequent period of credit inflation and the consequent explosion of financial innovation has taken us into another realm.  And, it is this new environment we are dealing with now.

Money can now flow almost anywhere at extremely rapid speeds.  Money can flow almost instantenously into different sectors of the financial market.  Thus a change in investor sentiment or the introduction of new information or a change in the stance of monetary policy can create “bubbles” in different sectors of the economy. 

We saw a growing occurrence of bubbles over the past 20 years.  We saw the dot,com bubble in the 1990s followed by its collapse in the early 2000s.  We saw the housing bubble in the early 2000s, followed by the collapse in the housing market in the latter part of the decade.  We seemed to have had stock market bubbles in both decades. 

Recently we seem to have had a bubble in international commodity markets due to the quantitative easing of the Federal Reserve system along with bubbles in certain emerging nation stock markets.  One can also make the argument that the recent behavior of the Treasury bond market represents a bubble.  How else can you explain the fact that the yield on Treasury Inflation Protected Securities (TIPS) has been negative.  Participants in the financial markets were not interested in TIPS for their yield but as a price play connected with the “rush to quality” in international financial markets.  (See Jeremy Siegal and Jeremy Schwartz, “The Bond Bubble and the Case for Stocks,” http://professional.wsj.com/article/SB10001424053111903639404576516862106441044.html?KEYWORDS=jeremy+siegel&mg=reno-wsj.)

Former Fed Chairman Alan Greenspan continues to claim that a bubble cannot be perceived before-the-fact, that is, before the bubble has burst.  Hence, the Federal Reserve could not fight off bubbles in financial (or commodity) markets because they could not be identified.  This seems to be the reigning philosophy of the current leadership at the Fed.   It is the old model of monetary policy.

Yet, the liquidity of international financial markets is a reality and the existence of bubbles is a fact of life.  I believe that these facts are being accepted by the people running our governments and central banks.   Yet, their thinking still has a ways to go and their model of how central banking should be conducted has not been completely formed. 

For one, these “leaders” seem to think that every problem they are facing is a liquidity problem.  I have addressed this earlier. (See http://seekingalpha.com/article/288610-the-debt-crisis-it-ain-t-over-until-it-s-over.) Thus, their solutions are systematically based on the maintenance of liquidity in international capital markets.

The fact that the market for an asset may be illiquid because it is related to cash flow problems, say as in real estate investment, and that no amount of liquidity will bring the value of the asset back to previous levels seems to escape these “leaders.”  That is, an asset is liquid, until it is no longer liquid.

Second, the model being used by these “leaders”, a model that places high economic growth to achieve low levels of unemployment, leads these “leaders” to adopt policies, like QE2, that are totally inappropriate for the current economic situation.  Providing liquidity in these cases may create further bubbles, as presented above, but may have little or no effect on economic growth or employment.

Fed Chairman Ben Bernanke is a very creative person.  He has been improvising monetary policy for the last three years.  The old model does not seem to fit any more.  Yet, a new model has not been created.  But, any new monetary policy must be based on the reality of today, a reality dominated by instantaneous flows of money to almost any where in the world.   

Keynes knew that you could not focus a nation’s economic policy on its own employment situation when capital flowed freely throughout the world.  That is why he created his macroeconomic model.  His followers, especially the fundamentalists Keynesians, don’t seem to understand this reality.   It is time to move on.  It is time to accept the reality of the “New” liquidity.

The Bubble in the Bond Market

There is an op-ed piece in the Wall Street Journal that I believe everyone should read. It is written by Jeremy Siegel and Jeremy Schwartz and is titled “The Great American Bond Bubble.” (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj) I believe this article is important enough and should be read even if you don’t exactly agree with the argument, which I don’t.

Siegel and Schwartz contend that the current “bubble” in the bond market is comparable to the bubble that occurred in the United States stock market in the 1990s. The reason for this bubble: “Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.” In effect, they argue, investors are too concerned about the possibility of slow economic growth and price deflation.

In order to make these “bets” investors have moved money from the stock market into the bond market. “The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”

My argument is slightly different. The Federal Reserve has held its target interest rate, the Federal Funds rate, in a range from zero percent to 0.25% since December 16, 2008 to the present. The yield on the 10-year constant maturity, United States Treasury issue has ranged over this time from about 4.00% to about 2.75% where it now stands at. The 3-year constant maturity has stayed in the 2.00% to 0.80% range.

Thus, investors could (and can) borrow money at close to zero interest and invest at a substantial spread...and THIS IS A RISK FREE TRANSACTION!

This is called the “carry trade”! Duh!

What about interest rate risk, the risk that interest rates will rise?

Well, the Federal Reserve, in its infinite wisdom, has taken care of that by promising the financial markets that it will maintain its low target interest rate for “an extended time.” Well, the “extended time” has lasted for twenty months so far and given the news coming out of the Open Market Committee meeting last week, it sounds like the “extended time” will last well into 2011.

The carry trade seems like it has a pretty safe bet for “an extended period of time.”

The Fed seems to be accomplishing two things in following such a policy. First, it is helping the Federal Deposit Insurance Corporation, the FDIC, resolve the problem of dealing with a massive amount of insolvent “smaller” banks in an orderly fashion. This work-out still has a long way to go by all accounts.

Second, the Fed is helping the federal government place massive amounts of debt. Never before has so much government debt been placed in the open market. And, given projections that the federal government will have to place $15 trillion or more of its debt in the next ten years, the Fed faces a daunting task of accommodating such a huge supply of Treasury securities.

The Federal Reserve has certainly accomplished some major things in helping the FDIC and the Treasury Department and in doing so has subsidized the large banks, major corporations, and other investment funds who could partake of the “carry trade” opportunities it created. Too bad if you are a smaller organization or don’t have the wealth to partake.

The Fed subsidy is lining the vaults of the large banks, the large corporations, and the large
investment pools. They are awash in cash!

And, we have a bubble in the bond markets!

This is the third financial market bubble in the last 15 years or so: the stock market bubble in the late 1990s; the bubble in the housing market in the 2000s; and now the bond market bubble. All of these are a product of the Federal Reserve.

I don’t disagree with Siegel and Schwartz in terms of the possible consequences of the current bubble.

“Those who are now crowding into bonds and bond funds are courting disaster.”

“Furthermore, the possibility of substantial capital losses on bonds looms large.”

“One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.” (Siegel and Schwartz contend, for example, that “The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1% or 100 times its payout.”)

However, given my argument, these consequent outcomes and the timing of them depends upon the Fed. The “extended time” will end at some point in the future and the Fed will have to let rates rise. When it does there will be a whole bunch of new problems it will have to face.

The Fed seems to be careening from one serious problem to another and appears to be “out-of-control”. (http://seekingalpha.com/article/220224-does-the-fed-even-know-what-it-s-doing-anymore) Over the past 15 years or so, the Fed has created one bubble after another, one problem after another, and now finds itself in an almost untenable position. It has pumped an excessive amount of reserves into the banking system. It is subsidizing the cash pools of large banks, large corporations, and large money interests. It has been overly accommodative to the financing of the debt of the federal government. And, now its risks bankrupting a large number of people, as Siegel and Schwartz suggest, when it ever raises its interest rate target. What next?

Bubble, Bubble...Where's the Bubble?

In Bloomberg Businessweek, Nouriel Roubini is quoted as saying “Zero interest rates are leading to an asset bubble globally…”

What is an “asset bubble” and how can one identify it?

Is an asset bubble like pornography? “I can’t define an asset bubble, but I know one when I see one!” Thank you Supreme Court Justice Potter Stewart.

Such a renowned economic prognosticator as former Fed Chairman Alan Greenspan couldn’t identify a bubble. He argued that you cannot identify an asset bubble before the fact. One has to wait until an asset bubble is over before you can identify it as an asset bubble. That sure builds confidence!

In Wikipedia, an asset bubble…or economic bubble…or whatever…is defined in the following way: An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.)

Others have spoken of a credit bubble. A credit bubble is a situation where the rate at which credit is flowing into the economy, financial markets or sub-segments of the economy or financial markets exceeds the growth rate of other parts of the financial markets or the economy causing the prices of assets in the economy, financial markets or a sub-segment of the economy or financial markets to rise much faster than elsewhere.

The example that quickly comes to mind is that of the housing markets in the 2000s where credit was flowing into this sub-segment of the economy at a much faster rate than elsewhere causing housing prices to rise much faster than prices were rising in the rest of the economy. Although, before the fact, as Alan Greenspan stated, he could not identify this as a credit bubble.

But, Roubini has stated that current Federal Reserve policy (“zero interest rates”) is “leading” to an asset bubble. The bubble is not here yet, but it is on-the-way.

What might be behind this argument?

Well, since December 16, 2008, the lower bound of the Fed’s target Federal Funds rate has been zero. Since that date the daily average of the effective Federal Funds rate has been between 8 basis points and 22 basis points: effectively zero.

Getting into this position of “zero interest rates” and “quantitative easing” the Federal Reserve, through the financial crisis in the fall of 2008, moved to increase the Reserve Bank Credit it injected into the system from $892 billion on August 27, 2008 to $2,245 billion on December 11, 2008, just before the “zero” interest rate target was approved by the Fed’s Open Market Committee.

Commercial bank held balances with Federal Reserve banks of $12 billion on August 27; on December 11 the total was $773 billion. In the month of August 2008, excess reserves held by commercial banks was less than $2 billion; in the month of December 2008 this total rose to $767 billion, an increase of more than 38,000%!

In the first six months of 2010, reserve balances with Federal Reserve banks and excess reserves in the commercial banking system both hovered around $1.1 trillion!

Federal Reserve releases have implied that the target interest rate will stay at such low levels for “an extended period” because of the weak economy. In recent weeks, analysts have argued that such low levels will be maintained into 2011. Now, a new study by Glenn Rudebusch of the Federal Reserve Bank of San Francisco (see “The Fed’s Exit Strategy for Monetary Policy”, http://www.frbsf.org/publications/economics/letter/2010/el2010-18.html, and as reported in the New York Times, http://www.nytimes.com/2010/06/15/business/economy/15fed.html?ref=todayspaper) argues that target interest rates may stay low into 2012!

“If the rate were raised too soon, it would be hard to reverse course, whereas if tightening is started too late, the Fed could catch up by raising rates at a rapid pace.”

But, interest rates are not asset prices! Asset bubbles or credit bubbles occur when credit (funds) flow into the economy or the financial markets or sub-segments of the economy or financial markets at a pace that exceeds the speed at which things are growing.

In the 2000s, we had excessively low interest rates and things were felt to be OK because the economy did not seem to be growing excessively and consumer price inflation appeared to be under control. Yet, we got the boom in housing prices…and, in stock prices. (Note, that neither of these prices is included in the Consumer Price Index. Housing costs are included through an imputed rental value which has very little to do with the price of a house itself.)

Much of the liquidity the Fed has pumped into the economy is, so far, just setting on the balance sheets of financial institutions…and, non-financial institutions. The commercial banks are not the only ones “piling up cash reserves. See “U. S. Firms Build Up Record Cash Piles,” http://online.wsj.com/article/SB10001424052748704312104575298652567988246.html?KEYWORDS=justin+lahart.

“The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.”

At some time, these cash balances, at financial institutions and non-financial institutions, are going to be used. The totals are so huge, I can’t imagine that “the Fed could catch up by raising rates at a rapid pace,” as Rudebusch suggests in his paper. When these cash balances are used, the impact will be on asset prices and not on consumer prices. This represents the potential for the “asset bubble” Roubini is talking about. And, remember, bubbles “break”!

Just one other point on this: I believe that what is happening in European financial markets is a part of this “bubble” activity. International investors are not acting like they are scared and strapped for funds. Their aggressiveness, to me, indicates that they are flush with money and hence have the confidence to be aggressive in attacking the financial condition of euro-zone countries on the sell-side. Investors “in dire straits” do not take on sovereign nations. This indicates, to me, that there are plenty of “well off” investors in the world that can move money around and “make things happen.” The European situation is a result of the U. S. “quantitative easing”. Further “quantitative easing” just exacerbates the problem!

Blame the Central Bankers more than the Private Bankers

“I cannot help thinking that the central bankers are escaping very lightly in the post-crisis dust-up. For while incentive structures in banking exacerbated the credit bubble, they were a much less potent cause of trouble than central bank behavior across the world.”

So writes John Plender in the Financial Times this morning (See “Blame the Central Bankers more than the Private Bankers”: http://www.ft.com/cms/s/0/58aa12a8-0575-11df-a85e-00144feabdc0.html.)

This article should be read!

One point that Plender makes is that maybe we need fewer academic central bankers and “more private sector bankers with a practical understanding of markets.” You mean heading up the Economics Department at Princeton is not enough to be the head of a central bank?

“The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targeting regardless of imbalances arising from easy credit and soaring asset prices.”

The consequence? An asymmetrical approach to monetary policy: “Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.”

This focus gave us the ridiculously low interest rates in the United States from 2002 through to 2004 and the subsequent asset (housing) bubble which accompanied them. This conclusion comes even after and “In spite of the bizarre recent assertion by Ben Bernanke…that the Fed was largely innocent in the matter of bubble creation.”

This mindset, Plender argues, is still around and is present in some of the approaches to fight systemic risk and to provide “macro-prudential” regulation and supervision. The mix of policy that these “academic” officials are proposing “suffers from the single disadvantage that it will not work.”

What Mr. Plender really asks for is central bankers that have less experience with the academic study of banking and financial markets and that have more practical experience in these markets.

The particular approach followed by central bankers, Plender continues, led to the rise in bank leverage which was “a far more important factor” in the crisis than was financial innovation.

How could this be?

Well, the incentive structures in banking placed emphasis on current bank earnings. And, the surest way to increase performance during the 1990s and 2000s was to leverage up the portfolio so as to earn a few more basis points. This behavior had to continue because competitors kept doing it. As “Chuck” Prince, the Chairman and CEO of Citigroup, so eloquently put it, if the music is still playing you must continue to dance. Competition demanded more basis points to keep in the dance for investor’s money.

And, the continued increases in leverage were underwritten by the monetary authorities who followed the philosophy of central banking described above. When the bubble burst, the leverage, of course, worked in the opposite direction.

I would highly recommend reading Plender’s article.

Lessons on How to Beat Deflation Trap

As the United States is gearing up for additional massive efforts in both the areas of monetary and fiscal policy we need to listen to the experience of other nations who have gone through recent periods of economic distress. We need to understand, as well as possible, just how this modern recession/deflation thing works.

There is a very interesting interview with Masaaki Shirakawa, a governor of the Bank of Japan, in the Financial Times today (http://www.ft.com/cms/s/0/18086fba-ca0c-11dd-93e5-000077b07658.html). One of the important things about this interview is the emphasis it puts on understanding what is happening in different sectors of the economy instead of just focusing on aggregate information. This has importance in understanding how recessions begin as well as for understanding the depth and length of recessions.

One of the problems with modern macroeconomics, as discussed in my review of Paul Krugman’s “The Return of Depression Economics and the Crisis of 2008” appearing on Seeking Alpha on December 9, 2008, is that macroeconomists want to focus on aggregates and not what makes up the aggregates. For example, capital is defined by one of the most popular text books on macroeconomics as “the sum of all the machines, plants, and office buildings in the economy.” And, all these component parts are perfectly and costlessly interchangeable.

The difficulty with this is, according to Governor Shirakawa, is that it does not allow for an understanding of the “imbalances” and “dislocations” that evolve during an economic expansion or during asset bubbles. Thus, when the economy is expanding the monetary authority needs to “watch carefully whether the broadly defined imbalances are accumulating or not.”

Furthermore, during these times, risk-taking and financial leverage tend to expand dramatically. It is not just aggregate demand or supply that is important in understanding the evolution of the economy but also what is happening in various sectors of the economy and how the financial structure needs to unwind.

And, experience has shown that these imbalances occur even when things like the consumer price index is behaving well. “Very often in recent decades we experienced a situation in which imbalances are accumulating, despite the fact that the inflation rate is quite subdued.” He continues that “Inflation targeting is one part of a good framework to explain monetary policy. But if inflation targeting creates the social presumption that the central bank can look at consumer price inflation alone, then it might have some unintended effect of helping the creation of a bubble.” That is, asset prices in different markets, housing, stocks, and so forth, must be observed also.

Why is it important to understand this?

We need to understand this because it points to the fact that recessions or periods of deflation cannot be handled by just appeals to pumping up aggregate demand. We need to understand that the previous upswing created imbalances, bubbles, dislocations, over-investment and these previous decisions cannot just be dissolved by assuming that all capital investment is alike and that stimulating aggregate demand is not the only thing that needs to be done.

But, Governor Shirakawa argues, this does not mean that monetary or fiscal policies are not needed in combating deflation and turning the economy around. Both are a part of a sound strategy to get the economy going in the right direction.

What is also important is a focus on the imbalances and dislocations that were created in the previous run-up. The policy makers need to understand how the various sectors are working themselves out and what, if any, bumps in the road lie ahead.

For example, the prime example of the ‘asset bubble’ just experienced is the housing industry. Until the summer of 2006, the housing market was ‘riding high’ with housing prices and housing starts seeming like they would never stop. Yet they did and housing prices have dropped steadily ever since. How far will they drop? Some analysts say that housing prices must drop to at least 50% of their peak value. Also, the picture gets even darker when one observes that there are still two major clouds hanging over the future. Both are related to the ‘financial innovations’ of the 1990s…major amounts of Alt-A mortgages and the Payment-Option ARMS are going to re-price over the next two to three years. The peak in housing foreclosures and personal bankruptcies is not expected to arrive for at least a year from now.

Another example is the financial industry. Tremendous losses have already been taken by banks and others, yet more are expected. The reason for this is that the banks still don’t fully comprehend the extent of the write-downs they are going to have to take on existing assets. Then, there is the fact that the banks have not yet seen the extent of the write downs connected with credit cards, auto loans, high-yield securities, and commercial and industrial loans. And, this doesn’t even consider the possible adjustments that will need to be made in the mortgage area mentioned in the previous paragraph. Mutual funds and hedge funds now are restricting investors who want to get their money back. And, then we are starting to see some of the fraud schemes surface that were a part of the recent credit inflation.

A further example is the auto industry (which also applies to other areas of manufacturing in the United States). I think everyone can agree that there are massive areas of imbalance and dislocation in this industry. Who is at fault? The auto executives? The labor unions? The politicians? The consumer? Everybody else? I don’t believe that any one person or group can be singled out as the cause of the problems in this industry.

But, I think that we can all agree that the problems are massive. These problems have to do with technology, innovation, out-of-date facilities, inappropriate pricing of resources, and other excesses that have been built into the structure over many years. Regardless of whether or not there is a bailout of this industry, it is going to take many years for the auto industry (and, I would argue many other areas of manufacturing in the United States) to really join the 21st century. Obviously, aggregate demand policies are not going to take care of the restructuring that is needed here.

Shirakawa summarizes: “Based on our experience, the world economy or the US economy needs the elimination of excesses. Of course the exact excesses vary from country to country…In today’s US for instance, housing is excessive; household debt is also excessive—I don’t know by how much, but anyways ‘excessive’ is there.”

“Negative feedback is now at work and I cannot give you a precise answer (to how long the global crisis is to run). What is crucial is to avoid a situation in which the adjustment leads to a serious downturn in the economy.”

In conclusion, there is no quick fix. The ‘excesses’, ‘imbalances’ and ‘dislocations’ in each sector must work themselves out. Monetary and fiscal policy may be able to soothe the pain…but they will not eliminate it. I tend to agree with Governor Shirakawa