Stockman's Corner

Good Riddance To QE—-It Was Just Plain Financial Fraud

by David Stockman

October 29, 2014

QE has finally come to an end, but public comprehension of the immense fraud it embodied has not even started. In round terms, this official counterfeiting spree amounted to $3.5 trillion— reflecting the difference between the Fed’s approximate $900 billion balance sheet when its “extraordinary policies” incepted at the time of the Lehman crisis and its $4.4 trillion of footings today. That’s a lot of something for nothing. It’s a grotesque amount of fraud.

The scam embedded in this monumental balance sheet expansion involved nothing so arcane as the circuitous manner by which new central bank reserves supplied to the banking system impact the private credit creation process. As is now evident, new credits issued by the Fed can result in the expansion of private credit to the extent that the money multiplier is operating or simply generate excess reserves which cycle back to the New York Fed if, as in the present instance, it is not.

But the fact that the new reserves generated during QE have cycled back to the Fed does not mitigate the fraud. The latter consists of the very act of buying these trillions of treasuries and GSE securities in the first place with fiat credits manufactured by the central bank. When the Fed does QE, its open market desk buys treasury notes and, in exchange, it simply deposits in dealer bank accounts new credits made out of thin air. As it happened, about $3.5 trillion of such fiat credits were conjured from nothing during the last 72 months.

All of these bonds had permitted Washington to command the use of real economic resources. That is, to consume goods and services it obtained directly in the form of payrolls, contractor services, military tanks and ammo etc; and, indirectly, in the form of the basket of goods and services typically acquired by recipients of government transfer payments. Stated differently, the goods and services purchased via monetizing $3.5 trillion of government debt embodied a prior act of production and supply. But the central bank exchanged them for an act of nothing.

Contrast this monetization process with honest funding of government debt in the private market. In the latter event, the public treasury taps savings from producers and income earners and re-allocates it to government purchases rather than private investments. This has the inherent effect of pushing up interest rates and, on the margin, squeezing out private investment. It is a zero sum game in which savings retained from existing production are reallocated.

To be sure, the economic effect is invariably lower investment, productivity and growth down the line, but the process is at least honest. When the public debt is financed from savings, government purchase of goods and services are funded with the fruits of prior production. There is no exchange of something for nothing; there is no financial fraud.

And it is the fraudulent finance of public deficits which is the real evil of QE because the ill effects go far beyond the standard saw that there is nothing wrong with central bank monetization of the public debt unless is causes visible inflation of consumer prices. In fact, however, it does cause enormous inflation, but of financial asset values, not the CPI.

Despite the spurious implication to the contrary, central banks have not repealed the law of supply and demand in the financial markets. Accordingly, their massive purchases of the public debt create an artificial bid and, therefore, false price. Moreover, government debt functions as the “risk free” benchmark for pricing all other fixed income assets such as home mortgages, corporate debt and junk bonds; and also numerous classes of real assets which are typically heavily leveraged such as commercial real estate and leased aircraft.

In short, massive monetization of the public debt results in the systematic repression of the “cap rate” on which the entire financial system functions. And when the cap rate gets artificially pushed down to sub-economic levels the result is systematic over-valuation of all financial assets, and the excessive accumulation of debt to finance non-value added financial engineering schemes such as stock buybacks and the overwhelming share of M&A transactions.

Needless to say, the false prices which result from massive monetization do not stay within the canyons of Wall Street or even the corporate business sector. In effect, they ride the Amtrak to Washington where they also deceive politicians about the true cost of carrying the public debt. At the present time, the weighted average cost of the $13 trillion in publicly held federal debt is at least 200 basis points below a market clearing economic level—–meaning that debt service costs are understated by upwards of $300 billion annually.

At the end of the day, the fraud of massive monetization makes the rich richer because it drastically inflates the value of financial assets—–roughly 80% of which is held by the top 5% of households; and it makes the state more bloated and profligate because its enables the politicians to spend without imposing the pain of taxation or the crowding out effects which result from honest borrowing out of society’s savings pool.

In the more wholesome times before 1914, the Federal government didn’t borrow at all. During the half-century between the battle of Gettysburg and the eve of World War I, the public debt did not rise in nominal terms, and amounted to just $1.5 billion or 4% of GDP at the time of the Fed’s creation. 

Even then, the Fed was established as only a “bankers bank” which could not own a dime of public debt, but instead existed for the narrow mission of liquefying the banking market by means of discounting solid commercial paper on receivables and inventory for ready cash.

The modern form of monetization arose in the service of financing war bonds, not managing the business cycle, levitating the GDP or boosting the labor market toward the artifice of “full employment”. These latter purposes reflect a century of “mission creep” and the triumph of the statist assumption that governments can actually tame the business cycle and elevate the trend rate of economic growth.

But history refutes that conceit. In the early post-war period, central bank interventions mainly caused short term bouts of unsustainable credit growth and an inflationary spiral which eventually had to be cured by monetary stringency and recession. In the process of repetition over several decades culminating in the 2008 crisis, the household and business leverage ratios were steadily ratcheted upwards until the reached peak sustainable debt.

Now the credit channel of monetary policy transmission is broken and done. The Fed’s most recent massive monetization and “stimulus” has therefore simply inflated financial asset values—-meaning that the Fed has become a serial bubble machine.

There is a better way, and it contrasts sharply with the systematic fraud of QE. That alternative is called the free market, and at the heart of the latter is interest rates which are “discovered” by the market, not pegged and administered by the central bank. Stated differently, the free market requires that all debt and other forms of investment be funded out of society’s pool of honest savings—-that is, income that is retained out of production already made.

Under that regime there is no fraudulent bid for public debt and other existing assets based on something for nothing. Markets clear where they will, and interest rates are the mechanism by which the supply of honest savings and the demand for investment capital, including working capital, are balanced out.

Needless to say, free market interest rates are the bane of Wall Street speculators and Washington spenders alike. They can spike to sudden and dramatic heights when demand for funds to finance government deficits or financial speculation out-run the voluntary pool of savings generated by society. So doing, they bring financial bubbles and fiscal profligacy up short.

In stopping QE after a massive spree of monetization, the Fed is actually taking a tiny step toward liberating the interest rate and re-establishing honest finance. But don’t bother to inform our monetary politburo. As soon as the current massive financial bubble begins to burst, it  will doubtless invent some new excuse to resume central bank balance sheet expansion and therefore fraudulent finance.

But this time may be different. Perhaps even the central banks have reached the limits of credibility—- that is, their own equivalent of peak debt.

“I think QE is quite effective,” Boston Fed President Eric Rosengren said in a recent interview with The Wall Street Journal, describing the approach as an option for dealing with an adverse shock to the economy.

October 28, 2014 6:37 pm
Europe’s banks are too feeble to spur growth
One doubts whether the capital in eurozone institutions is enough to drive the economy forward
James Ferguson illustration
Will the asset quality review and stress tests conducted by the European Central Bank and the European Banking Authority mark a turning point in the eurozone’s crisis? Up to a point. They are an improvement on what has gone before. But they are not a complete fix for the banking sector, still less for the economy’s wider problems.
The optimistic assessment is that the ECB has at least done enough to mend the banking system. There are two things to be said for this judgment: first, the ECB has taken a close look at the quality of assets in the system; and, second, the “stresses” imposed in the tests are tough.
They seem comparable to those imposed by the Federal Reserve on US banks. The ECB concluded that 25 institutions, nine of them Italian, would need to add a total of €25bn in capital. This number has already fallen to €13bn because of capital-raising undertaken this year.
Perhaps the most important possibility omitted by this assessment is that of sovereign default.

This bears on a fundamental concern: risk-weighted capital requirements, on which the analysis is based, involve making judgments about the safety of different types of assets. This is especially problematic in the eurozone, where the lack of a unified fiscal backstop for banks means that national governments are responsible for rescuing troubled institutions.

Moreover, the solvency of the eurozone’s highly indebted members is more doubtful than that of countries with their own currencies. Since a banking crisis would be even harder to deal with in the eurozone than elsewhere, it would be wise for its banks to have bigger capital buffers that stand a better chance of preventing one. This is particularly important when actual leverage is so much higher than the risk-weighted capital ratios suggest. (See chart.)

Fortunately, banks with the smallest amount of equity relative to actual assets are located in relatively solvent countries, such as the Netherlands, France and Germany. Nonetheless, leverage is 20 to 1 in Spain and Italy; 25 to 1 in Germany and France; and 30 to 1 in the Netherlands. It is question­able whether this is enough loss-absorbing capital.

High leverage also impairs the ability of banks to finance growth. A responsibly managed yet highly leveraged institution would seek to make heavily collateralised loans, against property, for example; or to hold highly rated assets. This is likely to militate against the productive investment the eurozone needs.


American Wellbeing Since 1979

J. Bradford DeLong

OCT 29, 2014

us doctor and child

BERKELEY – The story goes like this: Since 1979 – the peak of the last business cycle before the inauguration of Ronald Reagan as President – economic growth in the United States has been overwhelmingly a rich-only phenomenon. Real (inflation-adjusted) wages, incomes, and living standards for America’s poor and middle-class households are at best only trivially higher. While annual real GDP per capita has grown 72%, from $29,000 to $50,000 (in 2009 prices), almost all of this growth has gone to those who now occupy the highest tier of the US income distribution.
All of this is true, but there are a few important caveats. One is found in the Distribution of Household Income and Federal Taxes, published by the US Congressional Budget Office (CBO) last year. After-tax real income for the lowest quintile of US households was 49% higher in 2010 than in 1979, growing at an average rate of 1.3% annually. After-tax income for the middle three quintiles in 2010 was 40% higher – equivalent to 1.1% average annual growth.
To be sure, households in the 81st to 99th percentiles gained 64% in after-tax income, with the top 1% up by 201%, representing an average annual growth rate of 3.6% – far ahead of any other income group. And, by now, with the recovery concentrated among the rich as well, the top 1% of Americans are highly likely to be approaching a cumulative 300% gain since 1979.
But real income gains of 1.3% per year for the middle quintiles and 1.1% for the bottom are not exactly chopped liver, are they? The gap with 1.6% average annual growth rate for per capita GDP is small, isn’t it?
Well, yes and no. An optimist (or an apologist) could argue that, though market income has indeed become grossly more unequal since 1979, with the slots in the bottom half of the income distribution losing absolute ground in real income, and with taxation becoming less progressive, welfare-state growth substantially moderated this increase in inequality.
But when one looks at the 1.3% annual growth rate of after-tax real income that the CBO calculates for the bottom quintile, 0.9 percentage points comes from the growth of the health-care financing programs Medicare, Medicaid, and the State Children’s Health Insurance Program. The CBO counts all of that growth as an increase in poor US households’ after-tax real income. But that is not money that America’s poor can spend, so some downward adjustment should be applied.
Moreover, only half of those expenditures show up as more health care received by program beneficiaries; the other half flow into the general US health-care financing system and cover care that was previously uncompensated. And America’s health-care financing system is uniquely inefficient: other OECD countries get more in terms of health and healthcare services from every dollar they spend than America gets from every $2 it spends. As a result, a better estimate of the contribution of expanded US public health-care programs to the material wellbeing of America’s poor is just 0.2 percentage points per year.


QE, Parallel Universes And The Problem With Economic Growth

  • What do quantum mechanics and the theory of relativity have to do with global central bank policy?
  • Years of aggressive central bank policies haven't resulted in the type of accelerated global growth one might expect - is there an alternate universe where that is the case?
  • Breaking down the role of monetary and fiscal policy in generating growth, and what investors need to think about when such policies aren't delivering it.  

J. Brooks Ritchey
Senior Managing Director at K2 Advisors, Franklin Templeton Solutions

The current and prevalent view among some modern theoretical physicists is that our universe is not the only universe, but rather that there are many parallel or multi-verses that likely exist alongside or in tandem with ours. In the book The Hidden Reality: Parallel Universes and the Deep Laws of the Cosmos, author and physicist Brian Greene makes a compelling case for this remarkable possibility.

Greene describes that "the mathematics underlying quantum mechanics... suggests that all possible outcomes happen, each inhabiting its own separate universe. If a quantum calculation predicts that a particle might be here or it might be there, then in one universe it is here and in another it is there.

And in each such universe, there's a copy of you witnessing one or the other outcome, thinking - incorrectly - that your reality is the only reality. When you realize that quantum mechanics underlies all physical processes, from the fusing of atoms in the sun to the neural firings that constitute the stuff of thought, the far-reaching implications of the proposal become apparent. It says that there's no such thing as a road untraveled."

Bizarre. Greene goes on to describe that in addition to quantum theory, cosmological theory supports this freaky notion as well.

So to what purpose the Cliff Notes lesson in theoretical quantum physics? It suggests that there could be a universe, maybe multiple among the multi-verses, where the outcome to all of the central bank's quantitative easing efforts post-2008 has been sustained growth. One where the Federal Reserve's (Fed) Keynesian plan has worked accordingly, GDP growth is firmly and organically established, and everyone is living happily ever after. Just next to that universe, there may be another in which quantitative easing (QE) also worked to jumpstart the economy, but then an asteroid smashed into the Northern Plains of North America, and all of humanity was destroyed - truly unsettling. Fortunately for us, there has been no asteroid; however, growth has not yet taken hold either - and that is decidedly unfortunate.

The Universe of Economic Growth - or Lack Thereof

According to statistics from the International Monetary Fund, the G20 in aggregate appeared to be growing at a respectable 3% in 2013, but when examining the developed world's portion of that data, the "reality" that emerges is much less optimistic.1 The European Union (EU) grew 0.1% in 2013, and looks to be on a similar trajectory this year. The United Kingdom and the United States saw growth of 1.7% and 2.2% respectively in 2013. Growth in France was near 0%, and this year France, along with Japan and Germany, could be flirting with possible recessions.

Putting these statistics into perspective, despite the developed world having engaged in what is likely the most comprehensive monetary stimulation effort of the last 200 years, growth can best be described as middling. Without the fortunate shale revolution in the Northern Plains of the United States (and thankfully not the asteroid), growth there likely would be much lower, probably not much ahead of Europe today.

The good news about the universe in which we find ourselves, at least according to Modern Portfolio Theory, is that a truly diversified portfolio of uncorrelated and negatively correlated strategies/assets is still of value, in our view.2 Unsustainable fiscal and monetary imbalances often leave in their wake alpha capture potential - alpha being a measure of performance on a risk-adjusted basis - so we've got that going for us. The bad news is that there is no easy solution to the many problems and structural headwinds the developed economies of the world face, and without change, I think our global economy could likely remain stuck in a long gray plod of disappointing economic growth for who knows how long... infinity???

Two Schools of Thought

Before we imagine a universe that provides a path out of this economic quagmire, let's take a closer look at what got us here in the first place.

The arguments for and against QE can, for the most part, be distilled down to two very distinct schools of economic thought; schools that have served as the framework for the majority of modern economics and market theory taught in academia today. On one side we have Keynesian economics, theory based on the ideas of British economist John Maynard Keynes. On the other, we have Austrian economics, based on the ideas of a collection of academics - some of whom were originally citizens of Austria-Hungary (no surprise). At the risk of oversimplifying what are without doubt two extremely deep and detailed theories, to help structure our discussion I thought I would attempt to summarize each:

Keynesian Economics

In the simplest of terms (and we do mean simple), Keynesians argue that private sector business decisions may sometimes lead to inefficient outcomes, and therefore, government intervention is occasionally needed to step in with active monetary policy actions. These actions may be coordinated by a central bank. Generally, the Keynesian view believes that spending is what drives economic growth, and that deficit spending in a recession can be offset via fiscal surpluses in an expansion (and therein lay the rub).

Simplifying even further, let's consider Keynesian economics to be "the school of short-term economic planning."

Austrian Economics

Austrian theory, on the other hand, argues for very limited government intervention in the economy, particularly in the area of money production. Indeed, the Austrian school believes that central bank manipulation of economic cycles with artificial stimulus does more long-term harm than good, ultimately creating bubbles and recessions that are far worse than would be experienced in a natural economic cycle. This, then, would be "the longer-term school."

Who's Right?

To summarize, the Austrian school suggests that markets are self-correcting mechanisms that follow fairly smooth cycles, and that it is better to let nature run its long-term course (so to speak), as opposed to intervening when things may be less than optimal (i.e., recession).

Keynesians, on the other hand, believe economic cycles can be smoothened with tactical short-term government monetary intervention, and that fiscal policy may be modified occasionally to better guide market cycles. So which view is correct? Is it better to ease aggressively - and then ease some more when things are still not improved, or should the Fed simply remain on the sidelines and let the markets sort themselves out on their own? As they say, there are two sides to every story - and then there is the truth. Put differently, we do not live in an "either-or" world (or should not anyway), and the optimal application of economic theory - in my humble opinion, of course - probably lies somewhere in the middle of these two diametrically opposed views. Perhaps in some universe out there, this utopian equilibrium has been established, but clearly not in ours - at least not yet.

In practice, Keynesian thinking has generally guided most of the Fed's policy decisions post-World War II, and has certainly been front-and-center in the aftermath of the 2008 Lehman Brothers bankruptcy. Most would agree that the exceptional measures introduced by central banks around the world at that time - most decidedly Keynesian in nature - could be deemed appropriate in that they succeeded in restoring financial stability, while also preventing a full-blown global depression.

Subsequently, as the financial system stabilized, the justification for further QE became more rooted in the belief that such policies were again required to restore aggregate demand, particularly after the sharp economic downturn in 2009.

With each successive round of easing, however, the effectiveness of such policies in stimulating sustained growth is increasingly questioned, while the potential for longer-term negative consequences increases. Murmurs from the Austrian table in the back of the room begin to resonate.

So here we are with a global economics engine that has never really fully kicked back in, despite QEs one through three, and now the policies of Japan's Shinzō Abe and the ECB's Mario Draghi dubbed "Abenomics" and "Draghinomics" respectively. Where does it all end?

Armchair Quarterbacking

I do not presume to know more than those running the Fed in terms of economic policy making; however, this of course, does not preclude me from offering opinions on the matter.

While monetary weapons can be a good first step to remedying an economic crisis, they are clearly not enough on a standalone basis to return an economy to stability and growth.

Monetary medicine cannot heal fiscal ailments in the areas of budgeting, regulation, taxation and related policies. To return any economy to stable and organic growth, the aforementioned fiscal roadblocks need to be addressed - sounds Austrian, I know (more likely I'm somewhere in the middle).

My concern is that there has been an almost total academic capture of the mechanism of the Fed and other central banks around the world by neo-Keynesian thinking and hence policymaking, while the executive and legislative branches of the government have turned a blind eye to the necessary reforms.

So while the plan has thus far worked brilliantly for Wall Street, what central bankers have succeeded in doing is preventing, or at least postponing, the hard choices and legislative actions necessary by our politicians to fully implement a sustainable and prosperous future for our children - and theirs.

When I allow my thoughts to run in these directions, it can naturally be distressing at times. I remind myself then that I can only focus on the variables in my life that I can control, and among those are investment portfolio positioning. I often use a vehicle metaphor when discussing markets with friends and colleagues. When things are "risk-on," it is okay to take the red convertible sports car for a lively jaunt. When things are "risk-off," perhaps the solid sedan is a better option.

Today, I view the world as "risk-uncertain," and in these instances, I recommend the armored vehicle. That is a suitably diversified portfolio of alternative strategies, one that is focused on capital preservation and non-directionally driven market gains through strategic and tactical strategy allocations.

Alternative investments cover a varied set of asset classes and strategies that go beyond traditional stocks and bonds. Alternative investment asset classes include real estate, real assets (e.g., commodities, infrastructure) and private equity, while alternative strategies primarily consist of hedge strategies, including the use of derivatives. Hedge strategies typically have the ability to utilize short positions (i.e., seeking to profit on a decline in value of an individual security or index), in contrast to traditional mutual fund strategies, which typically permit only long positions.

I believe the prudence of such an approach to investment management is underscored given the current environment. That is, unless you find a way into another universe.

Brooks Ritchey's comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

What Are the Risks?

All investments involve risks, including possible loss of principal. The market values of securities will go up or down, sometimes rapidly or unpredictably. Foreign investments are subject to greater investment risk such as political, economic, credit and information risks as well as risk of currency fluctuations. Investments in derivatives involve costs and create economic leverage, which may result in significant volatility and cause losses that significantly exceed the initial investment. Short sales involve the risk that losses may exceed the original amount invested. Liquidity risk exists when securities have become more difficult to sell at the price they have been valued.

1. Source: IMF World Economic Outlook, October 2014. © by International Monetary Fund. All Rights Reserved.

2. Correlation is a statistical measure of how two securities move in relation to each other. Negative correlation indicates a relationship in which one increases as the other decreases. Diversification does not guarantee profit or protect against risk of loss.

And The Biggest Beneficiary Of QE3 Is...

By Tyler Durden

Created 10/29/2014 - 15:18

Aside from the S&P 500 of course, which made billionaires out of millionaires (even if it failed to make billionaires into trillionaires this time around -  we will have to wait for QE4 or QE5 for that), some may wonder: who was the biggest beneficiary of QE3?

It certainly wasn't the US middle class, which has seen its real wages decline in 6 of the past 7 months [7], and its disposable income is back at levels not seen since the mid-1990s.

No, the biggest winner of QE3 is the same entity that we noted benefited the most from QE over the past 6 years, and which even the WSJ realized was the primary beneficiary of the trillions in cash created out of thin air by the Fed, when in late September Hilsenrath wrote "Fed Rate Policies Aid Foreign Banks [8]"...  something we first said back in 2011 with "Exclusive: The Fed's $600 Billion Stealth Bailout Of Foreign Banks Continues At The Expense Of The Domestic Economy, Or Explaining Where All The QE2 Money Went [9]."
So when it comes to the Fed's QE3 generosity to foreign banks, what was the real number?
Here is the answer.
The first chart below shows that since starting in December 2012, when QE3 was formally launched, and continuing through today, the Fed injected some $1.3 trillion reserves with banks, which has manifested as extra cash held by various banks operating in the US, both domestic, but most importantly, foreign.
So how does this increase in bank cash assets look like when broken down by banking group? The answer is shown below:

And the bottom line:
  • Small domestic banks, such as your mom and pop regional bank which is anything but Too Big To Fail: change in cash: zero.
  • And the winner, with over $700 billion in extra cash added thanks to QE3, is: foreign (mostly insolvent European) banks.

So yes, European banks: feel free to send your thank you cards to the Fed: without its $1.3 trillion cash injection who knows how many of you would have passed the ECB's "no deflation to model" most recent Stress Test.

A word of warning: let's all hope that now, with some $1.5 trillion in Fed cash on foreign (most insolvent European) bank balance sheet, or just about half of all QE liquidity injections since the start of QE1, European banks are finally solvent. Or else, deflation, inflation, stagflation, hyperinflation, or what have you, the Fed will be storming right back in to bail out Europe's insolvent banks the US middle class all over again.