Why the US Government Would Be Bankrupted By Deflation

1. INFLATION IS GOOD FOR BORROWERS

Inflation benefits issuers of debt. This can be seen with the intuition that inflation makes each unit of currency less valuable every year. So in an inflationary environment, each dollar you borrow becomes worth less as time passes.

For an individual the link between your interest owed (mortgage, credit cards) and your cash flow (job, investments) may not benefit as quickly from inflation. Wages lag behind traditional metrics tracking inflation (CPI, PPI). For a business, however, the link is clear.

Suppose that you are CEO of Metal-Free Paper Clip LLC. Each year for 10 years the price of a paper clip has risen 10%. You have a great incentive to borrow to finance anything, because you can make 10% more revenue next year even if you sell the same amount of paper clips -- purely from inflation! So if you took a loan in 2004, each year inflation made it easier for you to pay your debt service.

2. LONG TERM INFLATION EXPANDS THE LIQUIDITY OF FINANCIAL MARKETS

When investors pour money into an asset, two things can happen. If the supply of the asset stays the same, then the price will rise. But if the price stays the same, you can bet good money that the supply has increased to absorb the new cash.

The latter is what happens every month in the market for US treasury bonds. We have already seen how exporting nations have huge incentives to reinvest dollar reserves in US government bonds. Since the price of these bonds (especially the shortest maturities) is not doubling and quadrupling every decade, we can be sure that the supply has been increasing. This can also be seen in the ballooning US national debt figure. That number is financed by government bonds.

The latest multidecade boom in world trade had set off a wave of inflation that made the US government bond market one of the most liquid in the world as exporting nations scrambled to reinvest currency reserves. This made it easy for our government to deficit spend and issue debt to make up the difference. All this debt issuance and spending further increased systemic inflation, which was fine with the government, since inflation benefits borrowers. Past debt could be repaid by an ever expanding market for future US treasury debt.

3. DEFLATION IS KNOCKING AT THE DOOR

The financial crisis has brought the prospect of a sustained deflationary environment closer to reality than it has been at any point in the post war period. This is frightening to those in government who are privy to our leveraged position. If world trade were to decline; if inflation were to decline; if the government bond market were to lose its increasing liquidity momentum, the government would be up sh@#$ creek without a paddle.

Deflation is good for debt holders. When prices are falling, they are promised a stable rate of return and preservation of capital. This is, of course, holding everything equal. If the debt you hold is US government paper and we continue our current deflationary cycle, then its bad for you too.

The government runs a gigantic ponzi scheme to finance its perpetual deficit spending. If the market for government bonds was to contract in a meaningful way, the government could go bankrupt overnight. This is compounded by the fact that the government went "all in" by using increased short term financing to retire long term debt. This exposes the US treasury to the same financing risk that took Bear Strearns out back by the woodshed.

2009 will be an interesting year. As with all declines, there will be wild switches made by consumers as their lives are affected. People will shift from ipods to food, with a million more switches to come as the recession deepens. This will provide opportunities for upside profit. But everything will be short-lived. We are still firmly in a deflationary spiral. Until government intervention takes hold, the case for a coming US currency/debt crisis is extremely compelling.

The Problems for Recovery: The Declining US Trade Gap

The US trade gap fell by 28% in November 2008. While this is a backward looking number, it is still horrifying. It means that the export economies of the world are under terrible stress. The US trade gap is the milk that sustains the infant economies that rely almost entirely on exports. Not that the US economy is supreme: it is an adult who is addicted to heroin. Our economy must get its fix of foreign credit or else the whole system will collapse.

This leaves the financial markets perilously close to the edge. The Chinese-American symbiotic liquidity cycle had analogues in Japan, South Korea, India, and all over Asia. This drove trade and cash flows between the US and many countries. Once US trading partners reached a certain level of economic sophistication, complex import-export linkages developed within the Asian ecnomies themselves.

This macroeconomic process drove the markets on the way up because it perpetuated rising asset prices. Higher prices meant more producers could profitably enter business. This led to increases in jobs, bank lending, and general economic activity. That in turn led to higher asset prices and so on.

The problem is that prices are falling, largely due to an acute global financial panic. This has thrown the feedback cycle in reverse. Falling prices put companies out of business. As firms consume less materials and labor (layoffs) money fails to reach places it used to. Retail firms fail and economies throw large amounts of workers into idleness. Ripples of failure perpetuate through the economy.

The only thing that can stop this cycle (maybe) are the governments of the world. Their actions are powerful, but take a long time to manifest. In the short term, a cycle of economic pain and destruction is unavoidable. 2009 may turn out to be a bad year.

But the rationale for an eventual recovery is compelling. The Federal reserve has engaged in stimulus policies that are unprecedented in the post WWII era. Ben Bernanke's rhetoric leaves no room for interpretation: he will do anything, including printing money, to avoid long term deflation.

This means that at some point the fed will go too far. Perhaps they already have. Prices will stabilize sometime in the next year or two. When that happens zero borrowing costs will inflate bubbles just by necessity. Someone will borrow for zero percent and lend for two percent, and the whole system will reflate.

Moral Hazard for Investment Bank Traders in the Era of Credit Expansion

In days of yore we had investment banks. These were banks that were not only engaged in bringing new securities to market, the traditional realm of investment banks, but were also buying and selling securities for the banks own account: a practice called proprietary trading.

The trader is allotted a certain percentage of total firm capital to trade. He draws a monthly salary and a bonus as a percentage of any trading profits. If he loses money he is fired.

So for the individual trader the following moral difficulties exist. On the one hand, if he makes a good trade he will pull down a large bonus for the year. This bonus will occur at the end of the year and will be based on any "booked" profit that the trader generated for the firm. But this can be calculated from positions that are still open, and thus still exposed to the risk inherent in any financial decision.

If he doesn't make any profit for the firm he will be paid his monthly salary until he is fired. While a firing has significant opportunity costs associated with it, we're assuming that there is little to no actual monetary loss to the trader associated with his firing (especially in relation to the total amount of proprietary funds the trader is allocated).

So how does the individual trader maximize the expected value of his job? To answer this we will assume that the trader has no actually edge on the financial market he trades: the probability of success (profit) in a year is 50/50.

In this case the trader has the incentive to take as large and as volatile a trade he can. In markets, assuming more risk is usually compensated by having a larger range of upsides and downsides. Normally this increased risk is avoided as the downside outcome is just as scary as the upside is tempting. But we must remember that the worst thing that can happen to a trader at a bank is get fired, which costs him relatively little.

In a financial transaction for an individual investor, he has the chances of both making and losing money. Thus if his chances for success are also 50% and his possible upside profit is A and his downside B, then he has an "expected value" of 0.5*A - 0.5*B. If A = B then the expected value is zero. This is the case usually confronting your average investor, but not so for proprietary traders at an old investment banks. In their case, B = 0 (or close to it), thus making their expected value always positive.

So to maximize their jobs (in terms of expected value) the trader must make A as large as possible, and the only way to do that is to take as large and as risky a bet as the bank will allow him. While this is rational for an individual trader, for the bank this is a recipe for disaster. No trader has any incentive to make sustainable long term bets for the good of the firm. Everyone is making short term decisions that maximize the year end bonus they will receive.

It is important to point out that I am in no way saying that these traders are evil. Any self-interested person would make similar decisions if presented with the same tradeoffs. Why wouldn't you? Nobody is going to get a prize for self-sacrifice at a bank.

I myself am a proprietary trader, although of a much different sort. My contract states that I can be sued by the broker/dealer (my boss) for any losses I may incur while using firm capital, which makes me much more judicious in choosing what strategies I employ! I believe that this model will take hold elsewhere on the street, from prop trading desks to hedge funds. Making managers and traders accountable for the downside of their actions is imperative if we are to fix the current problems we face today. Restoring confidence in the street starts with reforming the internal incentive infrastructures for managers and employees.

How Medicine Harms Health: Lessons from Perverse Tradeoffs in Driving

It has been well established that seat belts and other car safety equipment make people drive more recklessly than they would otherwise. The thought process is as follows. Drivers know that seat belts severely cut their risk of death and serious injury in a high-speed collision. Drivers who adopt the seat belt feel safer while wearing one.

Then, completely rationally, the drivers using seatbelts shift their "danger curve" down from the blue curve to the red one. Since for each trip your need to get somewhere is pretty much constant (excluding Sunday drives), it can be represented by a straight line, its scale on the right green axis.

This shifts the no seatbelt optimal trade off between driving speed, danger, and the need to get somewhere -- point A (the intersection between BLUE and GREEN) -- to the seatbelt optimum at point B (RED AND GREEN).

Point A corresponds to a speed of X and point B to a speed of Y. Y is greater than X, meaning people who drive with seat belts drive faster than they would without the safety restraints. If we use speed as a proxy for general recklessness, then we have proved my assertion. One would find similar results if we used percentage of brain devoted to driving instead of speed, but where the data would come from is beyond the scope of this blog.

Likewise, people face exposure to similar safety devices in other aspects of their daily lives: drugs and medicine. Consider replacing a constant "desire to live" as the GREEN line. If the horizontal axis represents the healthiness of a person's lifestyle, what effect would a similar shifting of the danger curve result in? A less healthy lifestyle filled with bad short term tradeoffs with the hope that medicine will save them in the long run.

The Treasury Bond Bubble: Yet Another Ponzi Scheme by the Fed

Image by Scorpions and Centaurs via FlickrThe chart below represents the iShares Barclay's 20-year Treasury ETF (symbol: TLT) which invests in long term US treasury bonds (20 years to 30 years). The price of this normally stable ETF rose nearly 30% from November 2008 to the beginning of 2009.

This explosion in value was due to the Federal Reserve's decesion to lower interest rates to a "range" of 0 to 0.25%. This action was taken in concert with large-scale buying of long term Treasury Bonds.

The Fed is essentially doing the largest refinance in history. The government is borrowing at 0% for three to six months and using the money to buy its own longer dated debt. This has the effect of raising long bond prices and lowering their yield (since in bonds, price and yield are inversely related). This lowers the government's long term borrowing costs. It all looks very good on paper.

The problem is that this strategy makes the Federal Reserve, US Treasury, and entire US gov't vulnerable to the same risks that brought down investment banks Bear Stearns and Lehman Bro's. These companies met their ends in large part because they relied on funding which had to be "rolled over" every three to six months. Sound familiar?

The government is doing the exact same thing. By relying on huge auctions of short term t-bills, the gov't is able to retire long term debt. But this short term debt comes due quickly, and thus must be paid back by selling new debt. This means that there has to be a long line of people willing to lend the government money at 0% for the forseeable future.

By relying on short term capital to fund the government, the Fed has begun the most desperate and risky stage of its intervention. This will either work a treat or lead to the comeplete unravelling of the financial system. There is no middle ground here, we stand on the pin-point of history. Either outcome will be spectacular.

The New January Effect: How the First Trading Day of the Year Effects Stock Market Volatility

The chart above shows why I will day trade the stock market on every first day of the year: the intraday volatility increases. Intuitively, the graph represents the amount (in percentage) that the first day volatility increases over "normal," which is defined as the average daily intraday volatility over the previous year. The first trading day affords an average increase in volatility of 0.52%.

Usually one has to try very hard to estimate when and where volatility will strike. But when you have a good idea of the timing of large price spikes your life becomes a whole lot easier.

Where the Next Bubbles Will Come From and How They Will End

One of the biggest problems with our current financial system is the fact that lower interest rates -- or the reasonable expectation of falling future interest rates -- encourages overinvestment. This inevitably leads to speculation and a subsequent asset price bubble. As Kindleberger states in his timeless "Manias, Panics, and Crashes" over trading through speculation will be followed by a "CONVULSION." Oftentimes this is some outside news factor that suddenly makes the boom model untenable.

In the case of the current crisis, the exogenous news factor was the pricking of another asset price bubble: the housing market. When ripples from the housing bust hit the banks of the world, it created a chain reaction. While our banks lost lots of money on their crappy mortgage exposure, their losses were dwarfed in magnitude by those experienced in the subsequent world stock market carnage. Some 30 TRILLION DOLLARS of wealth evaporated in 2008. But how much was made on the way up? Considering the current boom can be traced to the 1970's 30 trillion is just a drop in the bucket.

One lesson must be leaned from the thousands of years humans have used money and trade to lubricate their lives. Markets will have booms. Booms will lead to busts. But when the rate of interest is near zero percent: the urge to lever up will become too great.

Somewhere, sometime in the future, some trader at some bank will figure out that he can borrow from the fed for zero percent and lend for two percent. He will make a huge bonus and all his trader friends will do the same type of trade. The next year many traders will leave this bank and go to other banks and hedge funds. There they will tell tales of their trade, and they will borrow money at zero percent and lend money at two percent. Except when EVERYBODY does this, we will have another credit bubble.

The money lent out at 2% won't just sit in a drawer some where. It will be invested in some asset. If the speed at which money is being lent creates more money that needs to be invested than the supply of existing assets, prices will rise. But we can't use classical economics here. This is because while the supply of assets will certainly increase from bankers hocking IPO's and new bond issues, financial assets are not normal goods.

When a normal good or service rises in price, people consume less of it. When the price of a stock goes up, more people want to buy it. They see others making a killing and want a piece of their own. Likewise, when prices go down people sell more: they don't want to lose even more money. This means that credit bubbles become unstoppable reinforcing "virtuous cycles." These, of course, are followed by horrifying unrelenting market declines (vicious cycles).

Prices will stabilize. Money will be relent at too low interest rates. Money will be borrowed by firms and investors which will push up asset prices. More money will be lent. Some will go to increased demand for borrowed funds by speculators. They want to take advantage of rising prices. More money will be lent...