Decoding Bernanke

Martin Feldstein

29 July 2013

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CAMBRIDGEFederal Reserve Chairman Ben Bernanke has been struggling to deliver a clear message about the future of Fed policy ever since his May 22 testimony to the US Congress. Indeed, two months later, financial-market participants remain confused about what his message means for the direction of US monetary policy and market interest rates.
Bernanke’s formal statements about the Fed’s two unconventional policies have been clear. First, the Fed is trying to give relatively specific guidance about the future path of the federal funds rate (the overnight rate at which commercial banks lend to each other). Second, the Fed is indicating the conditions that will cause it to start reducing its massive monthly bond-buying program and eventually bring it to an end. Bernanke has emphasized that these two policies are on separate tracks and will respond to different indicators of the economy’s performance.
The Federal Open Market Committee (FOMC), comprising the Fed governors and the presidents of the regional Federal Reserve banks, has agreed that the federal funds rate will remain at its current near-zero level until the unemployment rate drops to 6.5% and can be expected to remain there or decline even further. With unemployment now at 7.6% and falling only slowly, the Fed may not be ready to raise the federal funds rate until 2015.
But there are caveats that make this forward guidance ambiguous – and therefore uninformative. The Fed warns that it might increase the federal funds rate if the anticipated annual inflation rate rises from its current level of a bit less than 2% to more than 2.5%. There is no clue, however, about how thatanticipated future inflation rate” will be determined. So the Fed could, in principle, decide to raise the federal funds rate even before the unemployment rate reaches 6.5%.
Moreover, the Fed recognizes that a substantial part of the decline in the unemployment rate in the past year reflects the large number of people who stopped looking for work (and who therefore are no longer counted as unemployed). So, if the unemployment rate is deemed to have fallen below 6.5% because of continuing declines in labor-force participation, or because firms increase the relative number of part-time workers (which would imply no increase in the aggregate number of hours worked), the Fed may not raise the federal funds rate.
As a result, it is not surprising that the market is confused about the likely path of the federal funds rate over the next 24 months. And that is important, because a rise in the federal funds rate will cause other, somewhat longer interest rates to increase as well.
The bigger policy uncertainty is about the more immediate prospect that the Fed may soon reduce its purchases of long-term assets – so-called quantitative easing. Bernanke continues to stress that shifts in the pace of bond buying will depend on how well the economy is doing. But he startled markets recently by saying that the FOMC’s expected path of stronger growth could lead to a slower pace of buying later this year and an end to the asset purchases by mid-2014.
Bernanke justified his position by stating that quantitative easing is intended primarily to increase the near-term momentum of the economy,” suggesting that stronger momentum would justify less asset buying. The reality, however, is that the economy’s near-term momentum has actually been decreasing ever since quantitative easing began – and has decreased more rapidly as the size of the program has grown.
The pace of real GDP growth fell from 2.4% in 2010 to 2% in the next four quarters, and then to 1.7% in 2012. The first official estimate of GDP growth in the second quarter of 2013, to be released on July 31, is likely to be less than 1%, implying that annual GDP growth in the first half of this year was considerably slower than in 2012.
So what does this imply about the Fed’s willingness to “taper” its pace of asset purchases? Ironically, it might help to rationalize the decision to begin tapering before the end of the year.
First, the lack of correlation between quantitative easing and GDP growth suggests that the pace of asset buying could be reduced without slowing the pace of growth. That is true even though, contrary to the assumption of Bernanke and some other FOMC members, interest rates will rise as the pace of purchases declines.
Second, if the extreme weakness in the second quarter is followed by a return to a sluggish growth rate of around 2% in the third quarter, the Fed could declare that it is observing the pick-up in growth that it has said is necessary to justify the beginning of tapering.
The policy of extremely low long-term rates is now doing more harm than good by driving lenders and investors to take inappropriate risks in order to achieve higher returns. Bernanke and the FOMC should recognize this and gradually bring the bond-buying program to an end during the next 12 months. They can take credit for what quantitative easing has achieved without holding its termination hostage to the economy’s future performance.
It is significant that Bernanke will be stepping down at the beginning of 2014. He did a remarkably good job in dealing with dysfunctional financial markets during the crisis years of 2008 and 2009.
When the financial markets were working again but the economy was still growing much too slowly, he turned to unconventional monetary policies to reduce long-term interest rates and accelerate the housing market’s recovery. So, although the economy is now weaker than he or anyone else would like, he may want to complete his policy legacy by beginning the exit from unconventional policies before he leaves the Fed. 
Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

Market Dominance

Friday, 26 July 2013

By Theodore Butler

In the weekly review, I referenced several news stories about JPMorgan. A few hours after publishing that report, another big news story made the scene – a comprehensive front page story in Sunday’s New York Times concerning the big banks and base metal warehouse shenanigans. In a nutshell, the story alleged that giant financial firms, like Goldman Sachs and JPMorgan, had amassed vast holding of metals warehouses and then engaged in schemes involving artificial metal movements for personal profit (at the expense of the consumer and user communities).

This story was followed by news of senate committee hearings yesterday and CFTC interest in the warehousing issue and more commentary about the Federal Reserve having doubts about whether the big banks should be allowed to deal in physical commodities. 
This issue is potentially as important as it gets. And it certainly begs the question I have asked repeatedly - why in the world should big banks be dealing in physical or derivatives on commodities in the first place?

Over the past few years, much has been written and discussed about the Volcker Rule that would outlaw proprietary trading by commercial banks. 
The main purpose of the proposed rule was to end the risks to the financial system caused by reckless speculation by banks backed by insured deposits that were deemed too big to fail. The idea of the Volcker Rule is to get the big banks out of proprietary trading and eliminate any need for taxpayer bailouts for big bets gone wrong. While the big banks have held the Volcker Rule at bay and prevented its enactment to date, it occurred to me that there is an even more compelling reason why these banks, and especially JPMorgan, should not be allowed to trade commodities for their own accounts. Potential risk is one thing; clear and present damage is another.

Quite apart from the potential risk that taxpayers may have to bail out a big bank on the wrong end of a speculative bet, there is clear proof of a greater actual damage that is occurring today. We are all suffering presently and mightily because of how JPMorgan and others conduct their proprietary trading in commodities. These big banks are not interested in trading commodities like any other market participant; instead their modus operandi is not just to trade in, but to dominate markets. This is my key pointJPMorgan’s intent and culture is to be the leader, to be number one, in any business activity in which it is involved. Being number one and dominating a particular business space may be fine in activities like investment banking and issuing credit cards, but the problem with this intent in commodity markets is that market dominance equals price control and manipulation.

There is no justification for there to be market dominance in any commodity market. In fact, this is the whole point in having commodity law and a commodity regulator, namely, to prevent dominance by any one entity. I’ve used the word concentrationendlessly and that’s just another word for dominance. If you allow concentrated holdings and little real competition, you invite price-fixing. This is the problem with the concentrated ownership of metal warehouses, but it is even a bigger problem in our regulated futures markets, where concentration and market dominance are verifiable.

The enactment of legitimate speculative position limits would eliminate and prevent concentration and market dominance (as I’ve advocated for decades) and it should be no secret that those who hold concentrated and market dominant positions, like JPMorgan, have killed any prospect of legitimate position limits ever coming into existence. If you held a dominant market position that enabled you to control prices and your own profits, wouldn’t you fight to keep that control?

Let’s face it – if I’m going to accuse JPMorgan of concentration and market dominance (and, therefore, of manipulation), I’d better be specific and accurate. In the past, I’ve pointed out JPMorgan’s concentrated short position in COMEX silver futures which had reached over 40% of the total net open interest a few years back. Back then, CFTC Commissioner Bart Chilton verified my findings publicly, but has since retreated from his past statements. So let me update my COMEX silver concentration findings and include specific data on COMEX gold.

In the CFTC’s Commitments of Traders (COT) and Bank Participation Reports of February 5, my analysis indicates that JPMorgan held a net short position of 35,000 contracts in COMEX silver futures. Once 50,000 spread positions are removed from the total open interest of 151,512 contracts (to arrive at true net open interest), JPMorgan held 34.5% of the short side of COMEX silver on Feb 5, little real reduction from the 40% that Commissioner Chilton confirmed years before.

Please allow me to state the obviousJPMorgan held a manipulative share of the silver market on Feb 5 and that controlling and dominant market share was primarily responsible for the fall in silver prices from $32 on that date to a recent low of $18 and change. For those keeping score, JPMorgan’s historic rigging of the silver price lower enabled the bank to reduce its share on the short side to less than 15% of total current COMEX net open interest. Certainly if I am misstating anything, I call on the CFTC or JPMorgan (or anyone else) to correct the record.

I’ve been writing a lot about JPMorgan’s COMEX gold position recently and I thought it might be instructive to talk about the bank’s concentrated and dominant market share of that market. On February 5, JPMorgan was net short around 50,000 COMEX gold contracts, with the price of gold at $1670. After removing approximately 70,000 spread positions from total gold open interest of 423,982 contracts on that date, there was a true net open interest on Feb 5 of 354,000 contracts. Therefore, JPMorgan short position of 50,000 contracts (or more) made up 14% of the entire short side of COMEX gold futures on a true net basis on Feb 5.

A 14% share of a market may not sound like much after I just stated that JPMorgan had held a 34.5% share of the silver market on Feb 5, but silver is very special when it comes to being manipulated in both level of degree and longevity. It would be a mistake to underemphasize the significance of a 14% net market share in any regulated futures market, especially one as large as COMEX gold futures with a total notional value of more than $50 billion. Let me return to the significance of such large percentages of concentration and market share dominance in a momento. First, let’s look at JPMorgan’s current long COMEX gold position.

Based upon the most recent COT report, as of July 16, I estimate JPMorgan’s net long position in COMEX gold futures to be 75,000 contracts. After subtracting 77,000 spread positions from total open interest of 440,283 contracts, true net open interest in COMEX gold futures is just over 363,000 contracts. Therefore, JPMorgan’s 75,000 contract net long position represents more than 20% of the entire COMEX gold futures market on the long side.

First, JPMorgan had a 14% market share on the short side and now they flipped that into a 20% share of the long side, as a result of JPMorgan manipulating the price of gold nearly $500 lower. These are extraordinary and dominant market shares and unprecedented price rigs to the downside. To not see them as cause and effect is to miss the obvious.

To get a perspective of market shares of 34.5%, 14% and 20%, you must measure them against some objective barometer. I would suggest using the CFTC’s own formula for position limits as the barometer. The formula (10% of the first 25,000 of open interest, plus 2.5% of the remaining open interest) would call for a position limit in silver of around 5200 contracts in silver, and not the 35,000 contracts held by JPM on Feb 5 or the 14,000 contracts that JPMorgan holds net short now in silver. In gold, the CFTC’s formula would call for a position limit of 12,875 contracts and not the 75,000 that JPMorgan holds long now. Expressed in percentage terms, the CFTC’s formula in gold would call for any one trader to hold not more than 2.9% of the COMEX gold futures market, yet JPMorgan currently holds 20% on the long side.

If you can remember back three years ago, I was bitterly disappointed when the CFTC devised their formula for position limits. Many thousands of public comments were sent to the Commission at my urging asking that 1500 contracts or 1% (of the entire COMEX market or of total world production) be the proper formula in silver.
Not only was the base rate of the formula two and a half times greater than the proper 1%, adding the much larger 10% provision on the first 25,000 contracts of open interest, artificially raised the effective rate to 5% for smaller open interest markets like silver. By the way, this provision was provided by the CME Group and was readily accepted by the CFTC.

As it turned out, I should have saved my disappointment for the eventuality that even the much larger 5% position limit in silver was too restrictive for the CME and JPMorgan. In the end, the enactment of position limits approved by the CFTC in conjunction with the Dodd-Frank Act was disallowed after legal action sponsored by JPMorgan. Now you know why we don’t have position limitsbecause it would limit JPMorgan’s manipulative hold on the market.

But by being specific and clear, I am hopeful that the current scrutiny being placed upon the big banks for their dealings in commodities might focus on the real issuemarket dominance. This is the key issue and it has gone unstated until now. According to the CFTC’s own proposed formula, no one trader should hold more than 3% in COMEX gold futures, yet JPMorgan holds 20% currently. Why is that allowed?

Years ago, the CFTC was successful in alleging manipulation in the copper market by a trader from Sumitomo called “Mr. 5%” for his share of the market. What should we call JPMorgan - “Sir 20%” or “Your Highness 34.5%”?

The important point is that my analysis is based upon publicly available data from the CFTC. That data indicate that JPMorgan holds an unnaturally large and dominant share of the gold and silver markets based upon any objective measure. Of course, a 20% or larger market share is not unnatural from JPMorgan’s perspective or culture and, quite frankly, that is the problem.

JPMorgan is only doing in the commodities market what it does in its other lines of business. But what it does elsewhere is manipulation in the commodities market.

Some may question whether I should even raise the issue of JPMorgan holding such a large concentrated and dominant long position in COMEX gold for fear its forced disposal might pressure gold prices. I understand those concerns, but as an analyst it would be dishonest for me to remain silent in the face of such compelling evidence of wrongdoing by this crooked bank. Besides, the chances of any immediate action by the CFTC are remote. Still, it would be far better to remove JPMorgan as the dominant participant in the commodities market and eliminate their incentive for continued commodity manipulation. Certainly, I shouldn’t have to be the one to urge the CFTC to do the job they swore to do, particularly when the proof of market dominance and control is contained in their own publications.

Finally, there continues to be an outburst of what I feel are misleading reports from within the precious metals Internet community. Some of the reports, from declining gold inventories on the COMEX, to stories about lease rates and backwardation in gold, to predictions of COMEX default or sudden changes in contract delivery terms, have my head spinning. Look, I’m bullish about the price prospects for gold and silver based upon the market structure and the fact that the silver cost of production is above current prices, but that’s no excuse for spreading false information. The level of COMEX inventories has little to do with a contract default. What would matter more would be short contract holders refusing to buy back or roll over positions in the spot delivery month.

A delivery default would kill the COMEX and it would be a self-inflicted fatality. The CME knows better than anyone what the consequences of a delivery default would be and they would take any measure necessary to prevent it, especially now that JPMorgan is massively long COMEX gold. The same goes for suggestions that the exchange would suddenly and unilaterally alter basic contract delivery requirements or institute a cash settlement. The term, futures contract, means there are rigid contractual requirements which can’t be suddenly abrogated without that being considered a legal default.

I suppose the CME could introduce new futures contracts voiding the physical delivery obligations of the current contracts, but that would take years and no one would deal in such phony contracts anyway. The one thing that gives COMEX metal contracts legitimacy is the ability to convert futures contracts into actual metal via delivery. The chance of the CME initiating a contract default in gold or silver, regardless of what warehouse inventories may be, are about as good as me stepping ahead of the new royal baby in future UK succession plans for the throne.

And I have to add that I don’t understand any of the current discussion of gold lease rates (and I am very familiar with metals leasing), for the simple reason that none of them make any sense. Let me be the first to say it – for a wide variety of reasons, GOFO is goofy.

Instead, as I indicated on Saturday, one market participant, JPMorgan, determines what will happen price-wise in gold and silver (and other commodities). This is a crooked bank that has no business controlling the gold and silver markets by its easy to document dominant market position. It’s encouraging that there is wide discussion on the unnatural control that big banks have on LME metal warehouses and that the Fed is reconsidering the wisdom of allowing banks to deal in physical commodities. But the most obvious danger of all is allowing JPMorgan to hold dominant market shares in regulated futures markets.

The Conglomerate Way to Growth

Ricardo Hausmann

25 July 2013

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CAMBRIDGECountries do not become rich by making more of the same thing. They do so by changing what they produce and how they produce it. They grow by doing things that are new to them; in short, they innovate.
Many countries have been altering their growth strategies to reflect this insight. But they are being distracted by some of the greatest – but atypicalexamples of success.
We all have heard of Steve Jobs, Bill Gates, and Mark Zuckerbergtwenty-something college dropouts who built billion-dollar companies at the cutting edge of global innovation. We have heard of the many start-ups that they and others acquired for hundreds of millions of dollars - Instagram, Skype, YouTube, Tumblr, and, most recently, Waze. So why not emulate these successes?
The main problem is that these examples are peculiar to the software industry, which provides a woefully insufficient blueprint for the rest of the economy.
The software industry is unique, because it has unusually low barriers to entry and ready access to a huge market through the Internet. A start-up is typically just a group of kids with a good idea and programming skills. All they need is time to write the code. Incubators provide them with space, legal advice, and contacts with potential clients and investors.
But consider a steel, automobile, or fertilizer plant – or a tourist resort, a hospital, or a bank. These are much more complex organizations that must start at a much larger scale, require much more upfront investment, and need to assemble a more heterogeneous team of skilled professionals. This is not something at which a young college dropout is bound to excel, because he lacks the experience, the organization, and the access to capital that these ventures require.
And, compared to software development, these activities also require more infrastructure, logistics, regulation, certifications, supply chains, and a host of other business servicesall of which demand coordination with public and private entities. Most important, these activities are most likely to be central to economic growth in developing and emerging countries. So, how will companies in these sectors arise, and what can be done to stimulate their formation?
Many developing-country governments are ignoring that question. For example, Chile’s government, obsessed with so-calledhorizontalpolicies that do not tilt the playing field in favor of any industry, recently implemented Start-Up Chile, a program with standardized rules to encourage new ventures. Although the rules were designed for all industries, the scheme attracts almost exclusively software ventures – the only ones that can be formed with the low level of support that the program provides.
Other industries face more daunting chicken-and-egg problems: countries lack the capabilities that growth industries demand, yet it is impossible to develop these capabilities unless the industries that require them are present. One way to solve this coordination problem is through vertical integration that is, firms that can solve internally the coordination of the supply and demand for any new capability.
That is why national business groups conglomeratesoften play a key role in transforming an economy and its exports. This is especially true in developing countries, where many markets are missing and the business environment is often extremely challenging.
Conglomerates can use their knowledge, managerial skills, and financial capital to venture into new industries. They can start things at a scale that would be impossible for a start-up. They can make credible commitments to future suppliers and influence the business ecosystem to make new industries feasible.
Consider South Korea. In 1963, the country exported goods worth less than $600 million at today’s prices, mostly primary products such as seafood and silk. Fifty years later, it exports goods worth almost $600 billion, mostly electronics, machinery, transportation equipment, and chemical products.
This transformation was not achieved through independent start-ups. It was done through conglomerates, or chaebols in Korean. For example, Samsung started as a trading company, moved to food processing, textiles, insurance, and retail, and then on to electronics, shipbuilding, engineering, construction, and aerospace, just to name a few activities. South Korea’s transformation was reflected in the transformation of its leading companies.
But, in many developing countries, conglomerates have not played an equivalent role. They have focused on non-tradable goods and servicesthose that cannot be imported or exported – and have eschewed international competition. They have focused on banking, construction, distribution, retail, and television broadcasting.
Once these companies dominate one market, they move to another that is equally sheltered from competition and devoid of export opportunities, often using their size and political influence to keep out would-be competitors. Instead of becoming agents of change, they often prevent change. (Indeed, the big economic debate in South Korea nowadays concerns whether the chaebols are stifling innovation by preventing start-up competitors from challenging them.)
The productive transformation that developing countries need is much easier to achieve with the support, rather than the obstruction, of their conglomerates. But ensuring such support requires policies that nudge (or even shove) conglomerates toward export industries that can grow beyond the limits of the domestic marketindustries in which competition will encourage the discipline that they lack as a result of dominating local markets.
To succeed, conglomerates need the support of government and the acceptance of society. They must earn it through their contribution to the growth of employment, exports, and tax revenues, and to the country’s technological transformation. That is what General Park Chung-hee (South Korea’s longtime ruler, and father of current President Park Geun-hye) pressured the chaebols to do in the early 1960’s. And it is what governments and civil societies in developing countries today should demand of their conglomerates.
Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist of the Inter-American Development Bank, is a professor of economics at Harvard University, where he is also Director of the Center for International Development.