QE2 Won, But Won’t Un-Block America’s Economic Stagnation, Now Keynes’ Nuclear BubbleOmics
Economics / Quantitative Easing Oct 10, 2010 - 07:01 AM GMTBy: Andrew_Butter
The justification for QE1 was that there was a “loss of control” and it was likely there would be a train wreck. The evidence that it was successful is that there was not a train wreck; although there was a bit of a scrape.
It’s impossible to say whether America and/or the World would be a better place if …
(A): The owners of toxic garbage had not been allowed to pass on $1.25 trillion of their mistake (owning them in the first place), to the Fed.
(B): The owners of the remainder of approximately $15 trillion of securitized debt that was created from 2000 to 2007 had not been allowed to value them at “face” (or thereabouts) for the purpose of calculating their (risk weighted) capital adequacy, or (for insurance companies and pension funds), their solvency ratios….so they could comply with Basel II, which incidentally says nothing about how you do valuations…what a joke.
(C): Shadow banks had not been allowed to change their status and use those toxic assets with their “friendly” valuations, as collateral to borrow from the Fed’s discount window, so they could “earn” their way out of trouble by using the Fed’s easy money to buy Treasuries and make a margin on the spread, taking advantage of the 0% risk weightings on that stuff, and you wonder why yields are going down?
(D): Bankers had instead; not been stuffed into sacks filled with snakes and thrown into the Thames (or the Mississippi), which was an idea put about after the South Sea Bubble popped.
But that was yesterday; doubtless budding PhD economists will be deliberating for years about whether or not that strategy was the best option, as opposed to simply letting the train crash and then starting from zero.
The point is that none of that happened, and so we are all living happily ever after, more or less, although that does not prove that the strategies that created the conditions for an “almost” train wreck, were smart.
One “problem” right now is that banks aren’t lending…because of…
(A): An improvement in lending standards (a good thing presumably)?
(B): A paralysis of faith in the process of valuation that has hiked up collateral requirements to unrealistically harsh levels.
That could have something to do with the realization that when you accept collateral for a loan, it’s not the price you could sell that for today that matters, it’s the minimum price you will be able to sell it for at some indeterminate time in the future, if (horror) your “customer” does not pay you back your loan (with interest).
If the “future” is asset-price inflation, then you are pretty safe, if that is not a given (and the way Treasury yields are going down, that is a serious possibility), then you need to think a lot harder.
That sort of valuation is a lot harder to do than mark-to-market (for that you look at the sticker-price in the supermarket – even accountants can do that), and more to the point, not many people know how to do one. Try asking your accountant if he know how to work out the “Other-Than-Market-Value” in accordance with International Valuation Standards.
I guarantee, he/she (well perhaps a better word would be “it”) will say…”Duh!!”
(C): An increase in the spread that banks are asking, to cover the “risks” in lending, which makes it more attractive to use equity, which negates the “stimulus” factor of zero base-rates.
(D): A sneaking suspicion (by anyone who holds them), that the toxic garbage currently warehoused, quarantined and rubber stamped by kiss-posterior FASB and/or IFRS, might not, in the future, be worth anything like the “nominal” valuations that are placed on them (and thanks to “Foreclosure-gate” that garbage is looking more and more toxic by the minute).
(E): A lack of desire by borrowers to create new lines of business in America due to the general uncertainty and/or structural issues affecting the interest of investors to take risks on new ideas (or upgrade and expand old ideas), in America. Sorry Tim-Boy bullying the Chinese to re-value won’t change anything, the reason no one is creating jobs in USA is because of you and people like you.
(F): The collapse of the securitization model, which was the primary mechanism supporting the creation of new debt from 2000 to 2007.
The “recovery” or fixing of that “machine” has not been helped by the attacks on the rating agencies, which (love them or hate them), were the essential foundation that house of cards was built on.
The fatal flaw of securitization as it was practiced in USA, (as opposed to the tried and tested Covered Bonds that have been used in Europe for two hundred years), was that the investors were not provided with access to the information they needed to be able to make sensible investment decisions.
Instead they were lulled into a false sense of security (a) by the rating agencies, (b) by the lawyers (who swore blind that all the paper-work was straight…another reason to never trust a lawyer since it looks more and more like in fact that was not true), and (c) by the “exchanges” which were supposed to prove that the market was liquid (and thus provide a basis for doing mark-to-market valuations), but in fact were rigged.
In that “market” a toxic RMBS was “worth” what you could sell it for, to the dumbest guy in the room, (and if that was you – well you had a problem).
Nothing has been done to get to the fundamentals of why that system went so badly wrong. Outside of pointing fingers....at, “greedy bankers, derivatives, rating agencies”…etc.
And absolutely nothing has been done to start crafting a replacement, like making sure investors have access to information they need and making sure that the valuations of the underlying collateral is done correctly.
How QE2 will fix all that is hard to figure out?
A common symptom of going broke is a denial of reality. We have all been there or we have seen it happen. The deadbeat spendthrift cousin or “old friend”, with delusions of grandeur and “dreams”; mismanages his business. Then the bailiffs are at his door, and he sends you an SMS begging you for just one more loan to tide things over.
Just one more bout of QE2 and everything will be OK.
What America does not have a shortage of is money created by the government’s agent (the Fed), the problem is that it’s in the wrong place and it’s not getting transferred from one pocket to another, and there is no evidence that another dose of QE will change that.
The Big Idea for QE2 is that QE1 didn’t actually do any harm, and in the circumstances (which are different now than then), it might well have done some good, and anyway traditionally QE strokes inflation, which is the opposite of deflation, so that might help “unblock” the pipes.
But there isn’t a lot of conviction in that argument.
In the end that logic degenerates into (a) the economy is suffering (b) someone “ought” to do something (c) in the past that “something” was lowering the base-rate (that isn’t an option anymore), and/or doing QE… and that (sort of ) worked last time, so why not?
But here’s the thing; that was precisely the same the logic that helped create the current mess.
A Medical Analogy:
In a recent article I came up with a snippet of, “toilet humour”…”banks got the “runs” and so the Fed supplied toilet paper”.
Carrying that one forwards, if you grow up in the “Third World” (like I did), diarrhoea (the runs), or what the swimmers at the Commonwealth Games are calling “Delhi Belly”, is a fact of life. You can call it “toilet humour” but where I grew up it was quite often a matter of life or death.
There are two ways you can deal with that:
Option A: You can take a pill (like Imodium), which increases the re-absorption of water in your colon and that “gums you up”.
That’s a quick fix and the result is that you don’t have to walk round with a roll of toilet paper in your bag in case you get caught short.
The downside is that doesn’t “cure” the disease, all it does is reduce the risk of de-hydration (which can kill you, particularly if you are a child, so there is a good medical argument for going down that route). But what it does is create a hard (putrefying) mass in your colon. So the next thing that happens is you need to take laxative to achieve “regularity” and persuade that solid lump to “evacuate”.
I.e. you take one pill to stop the flood of liquidity (like raising the base-rate if you are the Fed), then you take another pill (like QE or lowering the base rate), to get the whole show on the road again. And well if you take too many of the second pill, you will need some more of the first one….and round you go; like “boom-bust”.
That’s an example of treating the symptoms, rather than the cause, leading to negative feedback loops.
Option B:
Alternatively you can mix (boiled) water with glucose and sea-salt to get an isotonic solution (same as your blood), or alternatively you can buy a case of Gatorade (more or less the same), drink as much as you can, and basically let your body use the ammunition to flush out the toxins and the bacteria.
OK it’s not as quick a fix a popping a pill, and you have to more or less sit on the loo for a couple of days. But it’s a long-term fix, without side effects. That’s addressing the disease (washing out the infection), which is nature’s way, that’s why you get the “runs”, that’s nature’s way of dealing with the problem.
My Point:
An economy is “nature”; it’s a natural biological process that happens when you put human beings together. And sure you can control nature for a while, but only for a while; then you got a choice, do you destroy it (always an option) or let it regenerate out of it’s own forces.
In that analogy, what is “gumming up” the economy in America is a hard lump of $15 trillion of putrefying toxic assets that the government and their agent (the Fed) have elected to not wash clean.
Part of the problem is that no one knows what they are really worth.
As in what price rational investors who have access to enough information are likely to pay for them, in say two year’s time. Put that another way, like your deadbeat cousin, no one wants to know what that garbage is really worth because that would mean facing up to reality. And somehow, in the circumstances, printing $500 billion worth of toilet paper is preferable to knowing that.
Hank Paulson couldn’t figure it out (or come to terms with it) which is why he did an about-face on TARP. Nor could Tim Geither (remember PPIP where PIMCO & Co were supposed to put a value on it, that died); and one suspects that Bernake doesn’t have a clue what the $1.25 trillion of garbage he bought is actually worth (like what he might be able to sell it for in two or three years time).
Oh but if only the consumer comes back, everything will be OK!!
Dream on, the chances of getting the US Consumer to suddenly start maxing out their credit cards and “unlocking” equity from their homes, so they can “save” the American Dream, is not going to happen. Particularly since about 40% of those who have not done the “jingle-mail” thing are spending over 30% of their disposable income on “shelter”.
The correct long-term “fundamental” for that marker is about 22%, and OK they thought (or were persuaded), that was an ”investment” like “saving”, except the price of their homes went down, not up.
Anyone who thinks the American Consumer spending is going to save America (and the World), ought to apply for a job with the Federal Reserve. They need more people like that.
Bubbleomics is the word I use for the process of creating too much liquidity in an economy (or facilitating that), which typically causes asset-price bubbles, followed inevitably by the process of “gumming up”, and the unintended consequences of that. The sad reality is that the idiocy of yesterdays bad investments can’t just be forgiven with the wave of the Fed’s magic wand.
QE2 probably won’t do any harm. It certainly won’t precipitate hyperinflation, the number is just too small in comparison to the size of the mess, but there is no rational logic for why it should do any “good” outside of increasing the bonus packages of the illustrious banker elite.
One day perhaps the realization will dawn, that the real key to avoiding the unpleasantness of “the runs”, followed by “the gumming up”, is “not to start the fire in the first place”. Or if you are the organizers of the Commonwealth Games for example, is making sure you have enough chlorine in your pool, and preferably to put in a UV sterilizer as well. Or being practical, to make sure that your contractor does not skimp on the spec by paying kickbacks to the owner’s rep; which happens a lot in India. And in America too (but they are much slicker over there, it’s much more sophisticated than wads of cash in brown paper bags).
The Keynes Nuclear Option
I’m not an expert, but I don’t think that Keynes would have particularly supported the idea of paying-off moronic gambler-bankers as a way to recover from the hangover of ten years of “hyper-liquidity”, fuelled not by the Fed, but by securitization gone mad.
His Big Idea was that the government or its agent, borrows money (because it’s the only entity that realistically can at that point of the disease cycle – and if no one wants to lend it can print money), and uses that to invest or facilitate investment in long-term assets or infrastructure, that, in the long-term can be expected to be economically useful.
Since I’m not an expert, I may have this wrong also; but that’s not a totally new idea. That was the policy of Sheikh Rashid in Dubai, his idea was “we will build the infrastructure and the rest will follow”. OK Dubai lost the plot in 2004, but prior to that, building infrastructure and going with the Confucian idea of “keep the locals happy and attract foreigners (foreign investment) from afar”, worked like a dream. And I don’t think Sheikh Rashid got that idea from Keynes (given that he couldn’t read very well, and he hardly spoke any English). Perhaps Keynes got the idea from him?
Why nuclear?
Two reasons, the first is that there is a “tail risk” (we all know about tail risks these days), that’s the risk of the highly improbable, like a 200 Year Storm happening next week.
The highly improbable risk is that Global Warming is a reality, and that once the permafrost starts to melt in Siberia, releasing it’s load of methane, a feedback loop will start which will cause sea levels to rise not by a foot, but by 35 feet (all of a sudden, like over three years), which will put the lawn of the Oval Office on the sea http://www.marketoracle.co.uk/Article17330.html.
The probability of that happening, in our lifetimes, or the lifetimes of our kids and our grandchildren is about exactly the same as the probability that the rating agencies assigned to a load of AAA rated securitized debt going toxic, in other words, extremely unlikely.
But there again, like they say in Louisiana (quote)…”Shit Happens”.
Second, one of the reasons USA lives with a permanent current account deficit, is not cheap toys from China, or currency manipulation, it’s the amount of oil that it imports. The cost of that oil is not going down, particularly since the cost of discovering new supplies is going up exponentially, and it’s a similar story for coal.
Nuclear energy makes sense right now if (a) you can build a nuclear plant for $2 billion a GW (b) you don’t mind making a 6% Project Internal Rate of Return on that and (c) you can control prices, which would be perfectly possible by taxing the alternative fossil fuels so that the true cost (environmental plus the “hidden” cost of funding the current account deficit).
The reason you can build a nuclear power plant for less than $2 billion in Korea and China, and it costs upwards of $5 billion in USA, is simply politics and red tape.
So, if Keynes was not turning in his grave right now, he might well have suggested, to get rid of all the barriers to an efficient market that exist in USA, and use that $500 billion or more, to build 250 GW of nuclear power a year, for ten years.
And if you like fund that by taxing gasoline and heating oil to encourage development of hybrid cars, and perhaps electric ones (there is no point in doing that until the power-source is not fossil fuel). So “Hey Mr. Bernake, we can see you are having trouble getting it up (no I didn’t mean that “it” I meant inflation), so put a tax on gasoline, that would increase CPI at a stroke”.
75% of France’s electricity comes from nuclear; they never had a serious accident, interestingly the design of their plants was done in America.
Imagine what that would do to mop up all the construction workers in USA that got laid off when the house-building boom went bust? That would deliver much more long-term value to America than $500 billion of laxative slipped to the bankers so that they are “nice”.
But there again, with a government that happily spent $1 trillion (and counting), chasing imaginary WMD, you don’t expect much rationality or logic.
So don’t hold your breath.
By Andrew Butter
Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
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