Draghi's Do Whatever it Takes Beats Estimates

January 23, 2015

As always, the CBB is expression of my own views. It is in no way intended as investment advice. My objective is to chronicle history's greatest Credit Bubble and hopefully add some insight along the way.

Let’s return to where we left off in late-December: “Bubble On, Bubble Off.” The thesis remains that the “global government finance Bubble” was pierced in 2014. However, in a world of unprecedented liquidity excess, deflating Bubbles at the “Periphery” further inflate Bubbles at the “Core.” Last year saw faltering Bubbles in the Emerging Markets (EM) and commodities usher in a new King Dollar reign. While the Fed wound down QE, extraordinary measures by the likes of Draghi and Kuroda safeguard the historic boom in global leveraged speculation. 

Hot money flooded into U.S. securities markets. These trends run unabated in early-2015.

I’m also not backing away from the view that a prolonged experiment in global monetary inflation is “failing spectacularly”. The stakes are just incredibly high – financial, economic, social, geopolitical… Global policymakers refuse to admit their failings. They will not accept the obvious: printing “money” – creating perceived wealth through electronic debit and Credit entries – will not rectify the world’s ills. Indeed, runaway financial Bubbles lie at the heart of an extraordinary array of worsening global maladies. Disastrously, key central banks have coalesced into the stand that monetary measures have not been aggressive enough.

Especially here in the US, the notion of central bank policy failure is lampooned. My view emanates from “Financial Sphere vs. Real Economy Sphere” analytical framework. Central bank “money” creation further inflates already overinflated financial systems around the globe. This only exacerbates the dangerous divergence between inflating financial Bubbles and disinflationary forces that are overwhelming real economies. If anything, the problems associated with wealth redistribution and inequality – on a national as well as global basis – have become only more conspicuous as some Bubbles burst and others continue to inflate. The geopolitical environment is again noteworthy, albeit Ukraine, Russia, Yemen, the entire Middle East, Paris or Greece.

It is a myth that central banks control a general price level. It's mere folly that monetary policy spurs real and sustainable wealth creation. Doubling down on monetary inflation primarily exacerbates global market and Credit Bubbles. There is increasing risk of a crisis of confidence in the markets, in policymaking and in finance more generally.

This week saw German bund yields close at 36 bps. More incredibly, French sovereign yields ended the week at 54 bps – after averaging about 3.0% in the period 2009-2013. French yields averaged 7.0% during the nineties. Italian yields ended the week at 1.52% - after trading above 7% in 2012 and compared to the nineties average above 8.0%. Spain 10-year yields closed the week at 1.37% - after trading above 7.5% in 2012 (nineties avg. above 8%). Portuguese yields dropped to 2.44% - down from the 2012 high of 15.22%. European equities also celebrated “whatever it takes” Draghi. The French CAC 40 has posted y-t-d gains of 8.6%, with German stocks up 8.6%, Italian equities 7.9%, Portugal 9.6%, Finland 9.7% and Spain 2.9%.

A Friday Bloomberg headline: “Global Bond Markets Jump as ECB Buying Spurs Scarcity Demand.” Globalized “money printing” has inflated bond prices to historic extremes. One could certainly argue that ECB rate, bailout and QE policies have inflated a historic Bubble in European financial asset prices. I found the Q&A segment of Draghi’s press conference (after announcing the ECB’s plan for open-ended $60bn monthly QE) intriguing to say the least.

Question: “What do you answer to those arguing that a possible effect of the QE will be to rise some price bubbles on certain categories of assets?”

Draghi: “…We monitor closely any potential instance of risk to financial stability. So we’re very alert to that risk. So far we don't see bubbles. There may be some local episodes of certain specific markets where prices are going up fast. But to have a bubble… one should also identify the… dramatic increase in leverage or in bank credit. And we don’t see that now. However, as I said, we are alert and if bubbles are of a local nature, they should be addressed by local instruments, namely macroprudential instruments rather than by monetary policy.”

As Draghi’s policy course now mimics that of the Federal Reserve, so do his comments. Actually, his reference to “local episodes” recalls chairman Greenspan’s spurious claim that real estate was a “local market” – hence not prone to nationwide Bubbles. I countered at the time that Bubble Dynamics were prevalent throughout mortgage finance – and that the highly distorted Bubble market was very much a national (international) and policy-induced phenomenon. And Draghi’s assertion that the lack of a “dramatic increase in leverage or in bank credit” is inconsistent with Bubbles – and that “macroprudential” be used to counter localized excess – comes directly from the Fed’s playbook. So, what about central bank Credit? 

What about global “carry trade,” securities and derivative-based leverage? And why would “macroprudential” be viewed as a credible tool to counter securities market Bubbles when central bank policy is specifically designed to boost securities prices?

Question: “…What would you say to those who are concerned that ECB buying up bonds - electronically printing money - whatever one calls it, is the first chapter in a story that leads inevitably towards hyperinflation? What’s your response to that?”

Draghi: “…I think the best way to answer this is, have we seen lots of inflation since the QE program started? Have we seen that? And now it's quite a few years (since) we started. You know, our experience since we have these press conferences goes back to a little more than three years. In these three years we've lowered interest rates, I don't know how many times, four or five, six times maybe. And each time someone was saying, ‘this is going to be terribly expansionary. There will be inflation.’ Some people voted against lowering interest rates way back at the end of November 2013. We did OMT. We did the LTROs. We did TLTROs. And somehow this runaway inflation hasn't come yet. So what I'm saying is that certainly the jury is still out. But (there) must be a statute of limitations also for the people who say there will be inflation. Yes, when please? Tell me within what?”

For almost six years now, I have argued that the key issue is policy-induced market distortions and attendant financial Bubbles (as opposed to consumer price inflation). The history of monetary inflations is that once commenced they become almost impossible to end. This era’s policy experiment with manipulating securities market inflation makes certain that policy exits will be even more unbearable. Most regrettably, it’s reached a point where a global securities bear market will have devastating consequences – on markets, on economies and geopolitics. So central banks keep pumping and distorting markets – and market operators continue playing the game.

I believe we’ve now reached a precarious phase of instability where confidence in this global monetary experiment is waning. After all, there are years of experience to examine, along with rather conspicuous global financial and economic fragilities. Few have faith that “money” printing will rectify Europe’s - or the world’s - deep structural maladjustments. At the same time, there remains overwhelming confidence that acute fragilities ensure desperate policymakers continue to backstop the markets with liquidity abundance. Things do get crazy at the end of cycles – with lots of “money” slushing around to entice a wildly speculative marketplace. Increasingly, however, it is apparent that central banks have lost control of the massive pool of global speculative finance that they spawned and nurtured.

I believe history will look back to last October’s global, multi-asset class “flash crash” as a warning gone unheeded. Similarly, last week’s shock by the Swiss National Bank’s (SNB) to break the franc’s peg to the euro will also be seen as a harbinger of global market turmoil.

The post-SNB market shock was full of fascinating commentary. “A loss of trust.” One popular pundit called it “the worst central bank policy mistake in 40 years.” Most simply couldn’t fathom Swiss central bankers abruptly changing policy without providing the markets ample warning and time to adjust. This completely shattered the understanding that has developed over the years between market participants and their cherished central bankers.

Well, for much too long central banks have been making promises and assurances they will inevitably be incapable of fulfilling. SNB currency operations required the accumulation of several hundred billion of securities – with major ongoing euro devaluation ensuring huge portfolio losses. The Swiss instituted the extraordinary peg to the euro to stem capital inflows, believing back in 2011 that the crisis of confidence in euroland was of a short-term nature. But with Draghi about to move forward with shock and awe “money” printing, the peg was untenable. This currency link had created such enormous distortions that to ensure marketplace liquidity would surely have required a minimum of hundreds of billions of additional SNB purchases - and massive portfolio losses.

At this point, the sustainability of globalized market-based finance rests upon central bank assurances of “liquid and continuous markets.” It is this promise that underpins highly leveraged securities speculation that now encompasses the globe. It is the guarantee of liquidity and continuous market pricing that provides the foundation of global derivatives markets, especially hedging markets that rely on dynamic trading strategies (adjusting positions dynamically in response to changing market prices).

When the SNB ended the peg on January 15th, the swissy immediately surged 40% against the euro. A huge market dislocated in illiquidity. Those on the wrong side of currency derivative trades had no opportunity to hedge. Those leveraged (short) in swissy “carry trades” were instantly blown out. This wasn’t supposed to happen. This broke a cardinal rule between central banks and the markets.

At the heart of my premise is the analytical view that central bank market assurances sow the seeds of their own destruction. Promise markets stability, liquidity and price continuity and the resulting leverage, hedging and speculative flows will ensure an ugly day of reckoning – market illiquidity and dislocation. This is especially the case in today’s backdrop of a massive and growing pool of speculative finance. First of all, central bank policies are leading to only greater market excess and price distortions. Secondly, all the “money” printing inflates the scope of this “Crowded Trade” of speculative finance now hopelessly destabilizing global markets and economies.

Importantly, currency markets are in disarray. The Swiss franc dislocation provided an overdue reminder of how quickly highly leveraged trades can blow apart. It’s worth noting that this week’s losses in the New Zealand dollar (4.4%) and Australian dollar (3.8%) surpassed the decline in the euro (3.1%). New Zealand and Australian dollars have been popular “carry trades” targets. Eastern European currencies were under further pressure this week. The Singapore dollar, Malaysian ringgit and Turkish lira all declined at least 1% this week. King Dollar also inflicted more pain in commodities markets. WTI crude dropped 7.8% to an almost six-year low. The GSCI Commodities Index sank 3.0% this week (down 9.2% y-t-d) to the lows since early-2009 lows. All is not well in the global economy.

I would be remiss for not mentioning China. I actually believe unfolding Chinese Credit issues likely help to explain the absolutely dismal commodities performance, while perhaps also explaining the unrelenting bid to the dollar and Treasuries. China now faces the same dynamic that has plagued much of the world: liquidity injected to ameliorate Credit stress and spur economic activity instead stokes a speculative Bubble in the stock market. Chinese markets have exacerbated the global divergence between securities market Bubbles and deteriorating fundamental prospects.

For the most part, it was a big week for global equities – especially in Europe and the emerging markets. Market volatility is extraordinary, indicative of festering market structural issues. 

Short squeezes and the unwind of hedges can at any time spur market rallies. Yet there are further indications of insipient risk aversion and de-leveraging. Draghi’s do “whatever it takes” this week helped emboldened the bullish crowd. And QE does help accommodate the ongoing deleveraging in commodities and currency markets. QE also stokes “developed” sovereign debt market Bubbles. But I don’t see this endless “money” printing as confidence inspiring when it comes to global economic prospects. All this dollar-denominated EM debt remains a major issue. In the face of the ongoing QE onslaught, Credit conditions are tightening – in U.S. high yield, in China, in commodity-related corporates globally and EM generally.

Europe News

Aggressive ECB Stimulus Ushers In New Era for Europe

European Central Bank to Purchase €60 Billion in Assets Each Month Starting in March

By Brian Blackstone, Paul Hannon and Marcus Walker

Updated Jan. 22, 2015 10:57 p.m. ET

FRANKFURT—The European Central Bank ushered in a new era by launching an aggressive bond-buying program Thursday, shifting pressure to Europe’s political leaders to restore prosperity in one of the global economy’s biggest trouble spots.

Investors cheered the ECB’s commitment to flood the eurozone with more than €1 trillion ($1.16 trillion) in newly created money, sparking a rally in stock and bond markets and sending the euro plunging.

But in light of Europe’s underlying problems of stagnant growth, high debt and rigid labor markets, ECB President Mario Draghi suggested the central bank’s largess alone won’t be enough to right its economy.

“What monetary policy can do is create the basis for growth,” he said. “But for growth to pick up, you need investment; for investment, you need confidence; and for confidence, you need structural reform.”

The reactions to the central bank’s move rippled widely through the world’s trading floors, corporate boardrooms and European capitals. “It’s one piece of getting Europe back to growth, and we should see an impact,” Joe Jimenez, chief executive of drug giant Novartis said in an interview in Davos, Switzerland, where the political and economic elite are gathered for meetings of the World Economic Forum.

The effects also reverberated beyond the borders of the 19-member eurozone: Denmark on Thursday cut its main interest rate for the second time in a week, seeking to damp investor interest in its currency as investors sold the euro.

Mr. Draghi said the ECB will buy a total of €60 billion a month in assets including government bonds, debt securities issued by European institutions and private-sector bonds. The purchases of government bonds and those issued by European institutions such as the European Investment Bank will start in March and are intended to run through to September 2016. Mr. Draghi signaled the purchases could extend further if the ECB isn’t meeting its inflation target of just below 2%. In December, consumer prices fell 0.2% in December on an annual basis in the eurozone, the first drop in over five years.

The ECB’s new stimulus “should strengthen demand, increase capacity utilization and support money and credit growth,” Mr. Draghi said.

He rejected any criticism that the vast expansion of the ECB’s easy-money policies would stoke inflation down the road, noting that inflation has stayed very low even after several interest-rate cuts and abundant ECB loans to banks. “There must be a statute of limitations for those who say there will be inflation,” he said.

In a nod to concerns in healthier euro countries over the prospect of assuming risks tied to their neighbors’ debts, the ECB said government bonds will be mostly purchased by national central banks and excluded from potential loss sharing. Credit risks associated with the bonds of European Union institutions will be shared, however. “We are not in a one-country setup,” Mr. Draghi said.

Some critics say that separating credit risks along national boundaries undermines the principle of one monetary policy for the whole eurozone, a charge Mr. Draghi rejected.

Under quantitative easing, central banks create new bank reserves to buy assets from financial institutions. Central banks get bonds, and banks get money that they can in turn use to extend new credit to households and businesses. Such expansionary monetary policies usually weaken an economy’s exchange rate, which boost exports. The euro weakened to 11-year lows after the ECB announcement as European bond prices rose.

Officials also kept their main lending rate unchanged at 0.05% and a separate rate on overnight bank deposits parked with the central bank at minus 0.2%, meaning banks must pay a fee to keep surplus funds at the ECB.

But the new ECB stimulus isn’t quite as large as the €60 billion figure suggests. The ECB included existing purchases of asset-backed securities and covered bonds under programs launched last year.

Excluding those facilities, the new bond buys amount to about €50 billion a month, analysts said.

The launching of quantitative easing, which investors and many European governments have been pleading for, won’t necessarily solve Europe’s problems.

Former U.S. Treasury Secretary Larry Summers described the ECB’s move as a “broadly responsible central bank action,” but said governments still need to make policy reforms. “I think we need to realize the era of central bank improvisation as the world’s principal growth strategy is coming to an end,” he said.

The biggest challenge for QE is whether it can break the economic stagnation that has gripped the eurozone in recent years, which has led to the crumbling of public confidence in Europe’s institutions and its political class.

An anemic economic recovery since 2013 has left joblessness too high and output and inflation too low to escape the damage of the 2008 global financial crisis, which was compounded by the eurozone’s subsequent sovereign-debt crisis. Long after most other major economies have recovered from the financial crisis era, the eurozone remains burdened by high debts, bad loans, sickly banks, stressed households and anemic demand.

Stubbornly high unemployment rates in most eurozone countries apart from Germany have led to voter revolts against established political parties, fueling the rise of extreme or populist parties ranging from anticapitalist far-left to xenophobic far-right. Surveys show public trust in the EU and its bodies, including the ECB, has suffered too—although most voters across the eurozone remain firmly opposed to leaving the euro.

Not all members of the central bank’s governing council supported the decision to buy government bonds. Mr. Draghi said there was a large majority in favor of launching the program and unanimity that, in principle, buying government bonds is “a true monetary policy tool.” But some council members didn’t think it was necessary to buy bonds now. The ECB didn’t name opponents, but Germany’s two ECB council members have recently signaled their opposition to buying bonds.

Germany’s government is worried that the ECB’s move, by lifting growth and lowering borrowing costs, will take the pressure off eurozone governments to enact painful reforms.

“Now is the time to get our houses in order,” German Chancellor Angela Merkel said Thursday in a speech at Davos.

Despite those divisions, Thursday’s bond decision marks a new era for a central bank that was modeled on Germany’s conservative Bundesbank in the 1990s—at a time when fighting inflation was more of a priority than combating stagnation, weak consumer prices and recurring financial crises.

With official interest rates near zero and ample loans to banks failing to boost inflation so far, the ECB was left with few options apart from buying securities in the public debt market, thus raising the money supply. The ECB will cast a wide net for public debt, saying it would purchase securities with maturities ranging from two to 30 years. The ECB is also willing to buy bonds with a negative yield, which some short-dated German government bonds now have.

Central banks in the U.S., U.K. and Japan used quantitative easing extensively in the aftermath of the global financial crisis. While the Federal Reserve and Bank of England haven’t extended their programs amid solid growth and falling unemployment, Japan continues to deploy QE aggressively.

Still, many analysts question whether quantitative easing will work within Europe’s fragmented economy and banking system, particularly in stagnant economies such as France and Italy that have been slow to reform their labor markets to make them more flexible.

With Thursday’s move, which was more aggressive than financial markets had expected, Mr. Draghi passed the baton to governments to take the lead in restoring prosperity to the region’s economy.

Some business leaders shared the ECB chief’s assessment. “We have seen QE in the U.S. and Japan, but the key is structural reform. Without that it may not work and I see little sign (of structural reform) in key countries like France and Italy,” said Sir Martin Sorrell, chief executive of multinational advertising firm WPP.

The ECB’s move “was positive and it was needed,” said Francisco González, chairman of Spanish bank BBVA. He praised the slightly-larger-than-expected size of the ECB’s announced operation.

“Having said that, governments have to keep with reforms for the plan to meet its purpose,” he said.

—Gerard Baker, Khadeeja Safdar, Dennis Berman, David Enrich and Thorold Barker contributed to this article.

January 26, 2015 7:17 am
Who will blink now Syriza has won?
Three years ago, Syriza was only just recognisable as a modern political party. Today it is the new government of Greece, perhaps even with an overall majority in the legislature.
To implement its ambitious economic renewal programme, the party believes Greece must renegotiate debt arrangements and conditions with its creditors: the so-called “troika” of the European Commission, the European Central Bank and the International Monetary Fund. It has pledged to stop what Alexis Tsipras has called the “fiscal waterboarding” policies that have turned Greece into a debt colony and created widespread poverty and unemployment. In what promises to be the first serious clash between creditors and a sovereign debtor since the eurozone crisis began, someone is going to blink. But who, and with what implications?

The new government and its creditors do not have a lot of time, or much in common. Talks will have to start quickly on outstanding loan and repayment issues which fall due by March 1, and again in July and August, but these are more about process than substance.

The critical issue in the forthcoming negotiations is that a Syriza-led government will be quite unlike its predecessors, which had significant factions whose political interests were fundamentally aligned with those of the troika and with the basic thrust of austerity. Syriza has made no secret of its visceral opposition to the conditions that have been accepted until now.

It is possible that some sort of compromise could be reached over the terms of Greece’s debt, which stands at €317bn, or 175 per cent of gross domestic product. Roughly 80 per cent of debt is owed to the troika, and earlier restructuring has lengthened the average debt maturity to more than 16 years, with an effective interest rate of 2.4 per cent. Nevertheless, the burden of debt in a deflationary, slow-growth economy remains heavy.
Some creditors have already ruled out the demand for a write-off of much of the debt outstanding. But this and other possibilities could be explored, such as a clause that would tie residual debt servicing to realised rates of economic growth, even longer maturities, a lengthy grace period before debt servicing recommences, and some relaxation of the treatment of public investment in the Stability and Growth Pact rules.

Yet it is the concessions regarding austerity and the conditionality of the loan agreements that are likely to be the greater sticking point. No further major reductions in public spending are planned under existing programmes but tax and revenue increases are still expected to sustain austerity in an economy that remains in depression.

Syriza has had enough. It has declared the humanitarian crisis in housing, heating and food deprivation a priority, and intends to then act to restore economic growth, increase job creation, the minimum wage and pensions, and improve the collection of taxes and tax arrears.

Berlin and Brussels are likely to insist that Greece persist on its current course and implement already agreed policies, perhaps with tweaks here and there. A leading concern is to avoid the kind of concessions on debt terms and conditions that could give rise to claims for similar treatment elsewhere, including Spain, where Podemos, sympathetic to Syriza, leads the opinion polls in important national elections later this year. However, in creditor-debtor politics, the balance of advantage sometimes swings to the latter after a period of hardship and submission, as debtors gradually get their financial sea legs and political confidence back.
Greece may be approaching just such a point. Its budget deficit has just about been eliminated, while the primary balance, that is excluding interest payments, is predicted by the IMF on various measures to be between 3 and 5 per cent of GDP in 2015. Greece also has an external surplus of about 1 per cent of GDP, compared with a deficit of over 14 per cent in 2008-09.

It is hard to predict who will blink. A further and dangerous uncertainty arises from the condition of Greek banks, which had been experiencing deposit outflows before the election, and which remain dependent on nearly €50bn of Emergency Liquidity Agreement financing from the Bank of Greece, as approved by the ECB.

If Greece pushed its demands too far, approval could be withdrawn, triggering a new banking and economic crisis. The ECB could hardly approve loans, where the Greek government guarantor was attempting to dilute or cancel conditions. This could bring the Greek government down, lead to the imposition of capital controls, and in extremis provoke a political row that ended up finally in most people’s nightmare of Greece questioning continued eurozone membership. But the ECB, now doing QE, would hardly want to precipitate such an outcome.
The most we can say is that if Greece’s creditors blink, the significant demonstration effect to the rest of the eurozone will give rise to economic relief in the south and angst in the north, hardly furthering the cause of political unity. If Greece does, leaving its economic renewal programme toothless, the eurozone’s narrative of mistrust between north and south will intensify with dangerous political consequences.

Syriza has won an important victory, but a new chapter of European instability is only just starting.

The writer is an economic consultant and former chief economist to UBS

America’s elite

An hereditary meritocracy

The children of the rich and powerful are increasingly well suited to earning wealth and power themselves. That’s a problema

Jan 24th 2015

“MY BIG fear,” says Paul Ryan, an influential Republican congressman from Wisconsin, is that America is losing sight of the notion that “the condition of your birth does not determine the outcome of your life.” “Opportunity,” according to Elizabeth Warren, a Democratic senator from Massachusetts, “is slipping away.” Marco Rubio, a Republican senator from Florida, thinks that “each element” of the sequence that leads to success “is eroding in our country.” “Of course you have to work hard, of course you have to take responsibility,” says Hillary Clinton, a former first lady, senator and secretary of state, “but we are making it so difficult for people who do those things to feel that they are going to achieve the American dream.” When discussing the chances of ordinary Americans rising to the top, politicians who agree about little else sound remarkably similar.

Before the word meritocracy was coined by Michael Young, a British sociologist and institutional entrepreneur, in the 1950s there was a different name for the notion that power, success and wealth should be distributed according to talent and diligence, rather than by accident of birth: American.

For sure, America has always had rich and powerful families, from the floor of the Senate to the boardrooms of the steel industry. But it has also held more fervently than any other country the belief that all comers can penetrate that elite as long as they have talent, perseverance and gumption. At times when that has not been the case Americans have responded with authentic outrage, surmising that the people at the top are, as Nick Carraway said, “a rotten crowd”, with bootlegging Gatsby better than the whole damn bunch put together.

Today’s elite is a long way from the rotten lot of West Egg. Compared to those of days past it is by and large more talented, better schooled, harder working (and more fabulously remunerated) and more diligent in its parental duties. It is not a place where one easily gets by on birth or connections alone. At the same time it is widely seen as increasingly hard to get into.

Some self-perpetuation by elites is unavoidable; the children of America’s top dogs benefit from nepotism just as those in all other societies do. But something else is now afoot. More than ever before, America’s elite is producing children who not only get ahead, but deserve to do so: they meet the standards of meritocracy better than their peers, and are thus worthy of the status they inherit.

It takes two
This is partly the result of various admirable aspects of American society: the willingness of people to give money and time to their children’s schools; a reluctance to impose a uniform model of education across the country; competition between universities to build the most lavish facilities.

Such traits are hard to object to, and even if one does object they are yet harder to do anything about. In aggregate, though, they increase the chances of wealthy parents passing advantage on to their children. In the long run that could change the way the country works, the way it thinks about itself, and the way that people elsewhere judge its claim to be an exceptional beacon of opportunity.

Part of the change is due to the increased opportunities for education and employment won by American women in the twentieth century. A larger pool of women enjoying academic and professional success, or at least showing early signs of doing so, has made it easier for pairs of young adults who will both excel to get together. Between 1960 and 2005 the share of men with university degrees who married women with university degrees nearly doubled, from 25% to 48%, and the change shows no sign of going into reverse.

Assortative mating of this sort seems likely, on average, to reinforce the traits that bring the couple together. Though genes play a role in the variation of intelligence from person to person, this is not a crude genetic determinism. People tend to encourage in their children what they value in themselves and their partners. Thus people bought together by their education and status will typically deem such things important and do more to bring them out in their children, both deliberately and by lived example—processes in which nature and nurture are more than likely to work hand in hand.

Not only do graduate couples tend to value education; they also tend to have money to spend on it. And though the best predictor of an American child’s success in school has long been the parents’ educational level—a factor which graduates are already ahead on, by defintition—money is an increasingly important factor. According to Sean Reardon of Stanford the past decades have seen a growing correlation between parental income and children’s test scores. Sort the students who took the SAT, a test for college applicants, in 2014 by parental income and the results get steadily better the further up the ladder you climb (see chart 1).

First, cultivate your kindergarten
Another factor is family stability. Wealthier and better educated American families tend to marry before having children, and like most married couples they split up less than unmarried ones. This correlates with various good outcomes for their children.

The educational benefits of being born to wealthy parents are already clear in toddlers. Families which are used to and eager for success try to build on them at kindergarten. Competition for private kindergarten places among high-status New Yorkers is farcically intense. Jennifer Brozost of Peas, an educational consultancy, recommends that parents apply to 8-10 kindergartens, write “love letters” to their top three, and bone up on how to make the right impression when visiting. Some parents pay for sessions at which their children are coached on how to play in a way that pleases those in charge of admissions.

Once children enter the public school system—which about 90% of them do—the advantages of living in a well-off neighbourhood kick in. America is unusual in funding its public schools through property taxes. States have a floor price for the education of each child, but parents can vote to pay more local tax in order to top this up, and frequently do. Funding levels per pupil can vary by up to 50% across a state, says Mike McShane of the American Enterprise Institute, a think-tank.

Sometimes this results in poor students in cities that collect lots of property tax being better funded than the children of wealthier families in the suburbs. More often, though, the opposite is true. The result is that America is one of only three advanced countries that spends more on richer pupils than poor ones, according to the OECD (the other two are Turkey and Israel).

And on top of spending on school, there is spending outside it: the gap between what rich and poor parents shell out for museum trips, music lessons, books and so on has been widening (see chart 2). In a world where lots of people do well on SATs, cultivating extra skills matters.

The opportunities for parental investment continue in higher education, which is ever more costly (see chart 3) but offers ever greater returns. Between 1979 and 2012 the income gap between the median family with college-educated parents and one with high-school educated parents grew four times greater than the headline-grabbing income gap between the top 1% of earners and the rest, according to David Autor of MIT, rising from $30,000 to $58,000.

Those whose parents have provided good schooling and good after-schooling have advantages already—but some get an extra one from institutions that discriminate in favour of the children of alumni. According to a survey by the Crimson, Harvard’s newspaper, 16% of the 2,023 who got in last year had at least one parent among the university’s alumni. Harvard says that legacy preference is only ever a tie breaker in admissions; but with 17 applicants for every place there can be a lot of ties.

All this and lacrosse too
Most of the country’s research universities and liberal arts colleges grant preferences to legacy students; the practice seems widespread at universities just below the top tier. The University of Pennsylvania is particularly friendly to the children of alumni, says Katherine Cohen of Ivywise, a firm with several ex-deans of admissions on its books which provides advice on getting children into the best schools. Though it is rare, stories still crop up of the parents of academically borderline students buying admission for their children with a generous bequest to a particular school.

The fierce competition between universities to build endowments makes doing such favours for alumni enticing. And there is a public-good argument for it: a student who comes with $1m attached can pay for financial aid for many others. But in practice this is not how the system works. While it is true that some elite universities are rich enough to give out a lot of financial support, people who can pay the full whack are still at the centre of the business model for many. Mitchell Stevens, a Stanford sociologist who spent a year working in the admissions office of an unnamed liberal arts college in the north-east, found that the candidate the system most prized was one who could pay full tuition and was just good enough to make one of the higher-profile sports teams but had a strong enough academic record not to eat into the annual allocation reserved for students whose brains work best when encased in a football helmet.

Combined with the long-running push for racial diversity on college campuses, this makes for an esoteric definition of merit. Men are slightly under-represented across college campuses; African-Americans are not, but can still benefit from some forms of affirmative action; and there is always a need for those who are good at sports. Poor whites and Asians get a bad deal from this kind of filtering. Though the Ivies all deny operating quotas to limit Asian students—the best performing group in SAT scores—the number admitted each year has fallen from its peak in 2008and stays strangely consistent both from year to year and between institutions. Caltech, a university which admits purely on academic ability, has more Asian students than other elite schools. It also has much less feared sports teams.

On graduation, many members of America’s future elite will head for the law firms, banks and consultancies where starting salaries are highest. Lauren Rivera of Kellogg School of Management interviewed 120 people charged with hiring in these sectors for a forthcoming book. She found that though they did not set out to recruit students from wealthy backgrounds, the companies had a penchant for graduates who had been to well-known universities and played varsity sports (lacrosse correlates with success particularly well). The result was a graduate intake that included people with skin of every shade but rarely anyone with parents who worked blue-collar jobs. “When we are asked to identify merit,” explains Ms Rivera, “we tend to find people like ourselves.”

Something similar has happened in corner offices of America’s biggest companies. As computing power has increased and clerical jobs have been automated, the distance between the shop floor and executive positions has increased. It was never common for people to start at the bottom and work their way to the top. Now it is close to impossible. Research by Nitin Nohria, the dean of Harvard Business School, and his colleagues has shown how in the second half of the 20th century a corporate elite where family networks and religion mattered most was replaced by one whose members required an MBA or similar qualification from a business school. This makes the managers better qualified. It also means they are the product of a serial filtering that has winnowed their numbers at school, college and work before they get their MBAs.

More than 50 years ago Michael Young warned that the incipient meritocracy to which he had given a name could be as narrow and pernicious, in its way, as aristocracies of old. In America some academics and thinkers on the left are coming to similar conclusions. Lani Guinier of Harvard speaks for many when she rails against the “testocracy” that now governs America.

Once progressives saw academic testing as a way of breaking down old structures of privilege; there is now a growing sense that it simply serves to advantage those who have been schooled to excel in such situations. Heirs to Andrew Jackson on the right have their own worries about the self perpetuation of an American elite, but no desire at all to use government as a leveller. Both sides can agree that the blending of merit and inheritance is un-American. Neither has plausible ideas for what to do about it.

The European Central Bank Commits Monetary Suicide

By: Ed Bugos

Sunday, January 25, 2015


Yesterday the European Central Bank (ECB) announced an expanded 1.1 trillion euro (US$1.3 trillion) asset purchase program to start in March 2015 and continue through September 2016 (19 months) that will include the purchases of sovereign (national government) debt. It plans to purchase roughly 60 billion euros ($68 billion) worth of securities monthly, up from about 13 billion, with most of the additional purchases to be allocated to sovereign (national government) debt with a quarter expected to end up in scarce German bunds. The purchases will be restricted to investment grade issues, which would mean no purchases at all if the condition were applied diligently, and will include non investment grade issues like Greek bonds if they have an ongoing budget/spending agreement with the ECB-IMF in place.

The purchases will be limited to covered bonds, asset backed securities, and government debt (i.e., equity not included). A day prior, the Bank of Japan (BOJ) announced that it was going to continue its own asset purchase program (mainly JGB's), forcing insurers and other institutions to seek yields abroad.

The ECB program is twice as large as expected and the governing council appeared to be on side, including the German reps, owing to Draghi's apparently skilled diplomacy and risk sharing idea - where some portion of the losses would be born by the national central banks rather than the ECB.

The BOJ's pledge to increase its monetary base at the same 80 trillion yen per year ($676 billion) pace that it has for the past couple of years seems like a bit of a let down though given their bullish rhetoric to increase monetary interventions in 2015 following the Fed's final QE3 bond purchase.

Stock markets reacted positively around the globe, though gains were tempered (perhaps the news was a tad overly telegraphed!); bond yields ratcheted up a bit except in Germany and Switzerland where they have gone negative in some instances; the euro collapsed along with most currencies against the USD; the precious metals held up well; and the economically sensitive commodities fell.

A far more mixed day than I originally anticipated...but then, again, the moves were widely expected.

Fund managers and other institutions have been front-running this news for over a year.

Uh oh!

Ostensibly, the aim of the policy (intervention) is to combat deflation, or falling inflation, which the policymakers believe "reflects sluggish demand and can paralyze an already weak economy -- a problem that has long afflicted Japan, the world's third-largest economy" (click here for source).

It is aimed at boosting private sector investment and consumer confidence simultaneously, just like the Fed did in the U.S., proving, "the actual impulses for growth from sensible conditions must be created, and can be created, by politicians," said Merkel. Indeed, one source says, "The US Federal Reserve launched three rounds of bond purchases that were credited with helping jump-start the US recovery."

According to Bloomberg, "Global central banks are petrified of deflation," said M&G's Doyle, whose firm oversees the equivalent of about $389 billion. "The real effectiveness of QE is through the portfolio-rebalancing effect. The world is running out of positive-yielding government bonds."

It is a sad day when crap like this fools people.

You think an idea has died but most people are too dull to recognize it in a different wardrobe.

Like every good Keynesian, Merkel believes that throwing fresh money at sovereign governments can "create" growth? But the myth that anyone can produce wealth this way has long been exploded; as has the myth that government can produce wealth. Government can't create wealth because it cannot calculate whether what it is doing is efficient or economic, or whether it is wasteful. It can't coordinate resources inter-temporally between the various stages of production without knowing the prices of capital goods or the natural rate of interest. Nor can governments create wealth by expanding money supply anymore than they can turn stone into bread just by reading enough interpretations of Keynes.

All of this is pure noise.

The True Aim of the Interest Rate Suppression

What has weighed on Japanese growth and Euro growth is the same thing as that which is now weighing on growth in the US: a malignant public sector bureaucracy and out of control public debts.

Falling prices do not plunge the economy into a debt-deflation spiral, they are the product of gains in productivity - i.e., true growth is basically an increase in the supply of goods, greater output per capita.

The debt-deflation that is apparently feared by central bankers is in the first place a risk that was caused by fractional reserve banking - a concept that isn't broadly feasible in a free and unregulated market - and which is ultimately propped up by deposit guarantees, legal tender laws, taxpayer funded bailouts, and other monopoly legislation. The over use of the policy of suppressing interest rates has incentivized the accumulation of too much public debt everywhere. The real reason for the ECB's QE policy, besides having built it into the market (leaving no choice but to follow through on expectations), is to obfuscate the insolvency of the "fiscal cripples" that form the EU, and kick the can down the road.

There are long-term reasons as well, like the continued centralization of banking across the euro zone.

But the fear of deflation is an irrational fear fanned by a western alliance of central bankers to hide the fact that they are really just holding out a lifeline to the world's biggest and most insolvent governments.

For many months now in the TDV newsletter I have been writing about what has been happening in the US, and why it is not the same as growth. Now the ECB wants to do the same to the European economy.

The US economy is not growing faster, its asset markets are just being inflated faster.

Indeed, this fairy tale is part of what I believe is an even greater delusion.

The fact is that Europe (and Japan) has not inflated nearly as much as the rest of the world thinks, and not nearly as much as the Fed has, even in the latest year! The evidence strongly suggests that Japan and Switzerland sterilized their asset purchases while the US and UK did not.

And the verdict is out on whether the ECB plans the former or latter type of QE. This delusion is going to crush yen bears and dollar bulls in one fell swoop, and we warn you now to listen carefully.

Nobody owns the yen!

The Yen makes up the smallest allocation in everyone's portfolio.

Central banks own just 4% as currency reserves. And same with Japanese Government Bonds: as of a 2011 IMF report foreign ownership of Japanese government bonds amounted to just 5%.

On the other end of the spectrum is the US dollar, which makes up 61% of central bank reserves (down from > 70% at the outset of the euro experiment 1999-2001), and where foreign ownership of Treasury securities approaches the 40% level. Unlike the US dollar, which is over-owned, over-printed, and probably lies in bundles under every hooker's mattress, Yen is scarce, like Cesium! To boot, the Japanese money supply grew only 4% last year, despite all the rhetoric, compared to over 5% for Europe, and 7% in the US. It has grown just 22% in the past 5 years, cumulatively, compared to 33% for the Euro and over 70% for the USD!

Over the past ten years the BOJ has inflated money by just 32%! That compares to 102% for the Euro area and well over 100% in the US - the US has expanded money by 100% just since 2008- in roughly the same time period. The Swiss numbers for M1 are similar to the EU.

In almost every sense, the Fed has waged the most consistently aggressive monetary policy in the developed world, especially in the post 2008 period, where it has increasingly mirrored policies of countries like South Africa, Mexico, India, Indonesia, and Poland.

Even China has been pursuing a sounder money policy than the Fed since 2008.

Like we said, the US is not growing faster, it is inflating faster.

 QE Not the Same as Sterilized Asset Purchases

I first highlighted this delusion months ago in order to point out how the US treasury market and USD were benefiting from the relative suppression of European yields. In my analysis, strength in both the US dollar and US Treasury bond reflects the fact that yields on euro government debt have disappeared. This trade then was the source of the dollar's rally against the Euro.

If you listen to most media about this, you will come away with the idea the USD has been going up because the Fed has tapered and the US economy has gained traction while the Euro and Yen have been falling because their economies are relatively weak and their central banks have been printing money like mad. Indeed, the decline in the euro in response to the ECB's press release today should have been more guarded in light of the opposite truth. The market has been wrong about who is really printing money and who is dancing the twist. It is deluded about most things that support the dollar.

In light of this plus the fact that this overly expected event won't start for another month or two, and also because the Japanese central bank is lowballing its original promise there is risk of a hiccup.

Regardless, don't be fooled into thinking that this policy is going to help the private economy.

Inflation is what these cats want, and inflation is what they are going to get, good and hard.

One day soon they will be begging for deflation.

Read This, Spike That

Fighting Low Inflation in Europe, Keeping Investing Simple

Articles explain dangers of Europe’s deflationary spiral and virtues of a simple 60/40 asset allocation.

By John Kimelman    

Jan. 22, 2015 6:40 p.m. ET

The big stock-market news Thursday was the European Central Bank’s unveiling of its long-term bond buying program designed to goose the Continent’s struggling economy.
U.S. stocks gained broadly on the news, proving that Europe and the U.S. are consciously coupled in the minds of investors. (There’s really no other explanation for the broad-based rally.)
Press accounts of the ECB’s bond buying plan point to the effort of central bankers to fight the weak inflation that tends to accompany a struggling economy. All other factors being equal, pumping money into a system tends to be inflationary. But why are low prices in and of themselves so bad?
A decent explanatory piece by Bloomberg provides some answers. Using language that a grade schooler can understand, the piece explains how low prices beget even lower prices, hurting both business and underlying stock values in the process.
“When shoppers see persistent price declines, they hold out on buying things. They ask, will I get a better deal next week, next month, next year? As a result, consumer spending flails,” writes Bloomberg’s Shobhana Chandra. “For most nations, that’s a big chunk of their economy, and any slowdown in consumption threatens growth.”
Of course, one isn’t going to postpone buying needed consumer items like a quart of milk or, in my case, coffee. In that respect, the explanation seems lacking. But for bigger ticket items, this explanation makes sense.
Chandra writes that businesses behave pretty much the same way. “They postpone buying raw materials, hoping to get a break on costs, and delay investing in that splashy new facility or hiring an extra hand.”
In addition, she writes, these businesses’ pricing power — the ability to charge more — vanishes, making it harder for them to grow profits. “In such an environment, if companies want to grab a bigger market share, they have to slash prices. That makes things worse.”
Meanwhile, a couple of investment articles caught my eye.
Since the research shows that asset allocation decisions weigh more heavily on an investor’s final results than individual security choices, I am always interested in good stories about asset allocation, even though they may lack the excitement of a good yarn about an interesting stock.
Writing on his blog, The Reformed Broker, financial advisor and market pundit Joshua Brown refers to some fresh research by the respected shop Research Affiliates, which makes a great case for holding to an asset allocation of 60% stocks and 40% bonds for the long run.
“RA takes a look back at the last ten years and calculates the annualized return of a classic 60% equity / 40% fixed income portfolio versus 16 pure asset classes on their own. The 60/40 portfolio generated 7.2% annual returns (nominal) from 2005 through the end of 2014, edging out 9 of the 16 asset classes in their data set and with significantly less volatility than most as well,” Brown writes.
“Are there better ways to invest than the classic 60/40? Sure there are,” Brown writes. “Will you be able to identify them in advance? Can you bear the added risk of a portfolio tilted toward higher expected returns, through the really rough times where that extra return is actually earned? What are the costs associated with supposed ‘better’ investment strategies? Can they be justified on an after-tax, net of transaction expense basis? Those questions are probably some pretty high hurdles for a lot of the so-called “better” or more exciting strategies to surmount, no?”
A piece by StreetAuthority writer Joseph Hogue touts the merits of playing a long-term investing trend with a few stocks. That trend, according to Hogue, is the trillions of dollars of high-net-worth baby boomer wealth that will be passed to younger generations over the next 30 years.
“More than $6 trillion is set to change hands in the U.S. alone and more than 30% is in liquid assets and could be easily spent,” he writes. “If that were not enough, this transfer of high-net-worth assets is only a fraction of the world’s $241 trillion in wealth, much of which will also transfer over the next three decades.”
Hogue argues that luxury-brand stocks Estee Lauder and Coach will benefit from this trend, among others.
“The transfer of wealth and increasing means of the wealthy should act to drive sales for luxury brands even while the future is less certain for discount retailers,” writes Hogue.
While I don’t doubt that this wealth-transfer trend will occur, I question whether the aforementioned luxury brand stocks will necessarily be the recipients. Who can tell whether they will be selling what the rich of tomorrow want?

January 22, 2015 3:17 pm
Draghi opens Europe’s monetary spigot at last

Eliminating eurozone deflation will require sustained treatment
It has taken far too long for the European Central Bank to embark on quantitative easing but its belated action is no less welcome. On Thursday, Mario Draghi announced that the ECB will purchase €60bn per month of eurozone bonds up to the end of 2016 to fight off incipient signs of deflation.
Mr Draghi faced a daunting challenge in meeting expectations of a monetary boost that have grown all year. Thursday’s initial market response is that he did not disappoint. At the time of writing, the euro has weakened significantly against other major currencies.

There is no doubt that Mr Draghi needed to act. Growth and underlying inflation have been relentlessly weak, providing clear evidence that demand in the eurozone is faltering.

Critics have deployed many arguments to delay eurozone QE. None is convincing and taken together they are incoherent. Pessimists argue that monetary stimulus cannot work in a world of low interest rates and cautious banks. Inflation hawks fear that money printing leads to runaway inflation. Others complain that buying the bonds of struggling countries “rigs the market” and eases the pressure towards structural reform.

Clearly these critics cannot all be right, and it is likely that none is. Hyperinflation is one of the more fanciful bugbears of this recovery. In any case, most developed economies would clearly benefit from higher inflation, and central banks have any number of ways of reining it in, should that become necessary.

The claim that monetary policy is inert when interest rates are low is belied by the recoveries in the US and UK. Switzerland provides even starker proof. In 2011, the imposition of a cap on the value of the Swiss franc loosened money and helped growth. Its removal has sharply tightened Switzerland’s monetary stance and could now throw it deeper into deflation. The level of interest rates plays no clear role in this switchback ride.
That is just as well, because bond yields across Europe have been plumbing record lows: less than 0.75 per cent in Germany and France, and 1 percentage point higher for Italy and Spain. The most valid criticism of QE is that with government borrowing being nearly costless, fiscal policy should take more of the strain.
Low bond yields are an expression of doubt in the markets that the ECB will be effective in restoring growth and inflation. Such reservations reflect the constraints under which Mr Draghi has to labour.

His most potent weapon ought to be an ability to commit to whatever is needed to hit his target.

Markets are ill inclined to fight a steadfast central banker. On the flipside, consumers and businesses who doubt that inflation will be high have less reason to spend or invest. Mr Draghi has been hampered from being so resolute by the recalcitrance of others at the ECB. After Thursday the indications are that he is up for the fight, particularly in his hint that QE will be open-ended until there have been a “sustained adjustment” in inflation back to its 2 per cent target.

Less welcome is a confirmation that national central banks will be forced to bear most of the default risk from bond purchases. While this should not stop QE gaining traction, it may cast doubt on the endurance of the policy.

To escape years of enervating weakness the eurozone needs not just a shot in the arm but a long course of treatment. Neither the markets nor his ECB critics think that Mr Draghi has the tools to finish this job. For him to prove them wrong, eurozone governments should show equal resolve.

Davos oil barons eye $150 crude as investment slump incubates future crunch

Roller coaster move in prices is destructive for the oil industry and is leading to investment cuts that may store up serious trouble for the future

By Ambrose Evans-Pritchard, in Davos

7:46PM GMT 21 Jan 2015

Rampant speculation by hedge funds and a rare confluence of short-term shocks have driven the price of oil far below its natural clearing level, coiling the springs for a fresh spike this year that may catch markets badly off-guard once again.

"The price will rebound and we will go back to normal very soon," said Abdullah Al-Badri, Opec's veteran secretary-general. "Yes, there is an over-supply, but fundamentals don't justify this 50pc fall in price."
Experts from across the world - from both the West and the petro-powers - said the slump in fresh investment in 2015 is setting the stage for a much tighter balance of supply and demand, and possibly a fresh oil crunch.
Mr Al-Badri said he had been through price swings before but recovery may be swifter today than in past cyclical troughs. "This time we have to be very careful to handle this crisis right. We must keep investing, and not lay off experienced people as we did last time," he told the World Economic Forum in Davos.
Claudio Descalzi, chief executive of Italy's oil giant ENI, said the last phase of the price crash from $75 a barrel to around $45 was driven by wild moves on the derivatives markets. Traders with "long" positions effectively capitulated once it became clear that Opec was not going to cut output to shore up prices.

This led to abrupt switch to massive "short" positions instead. "These contracts are 15 or 20 times the physical market," he said.

Mr Descalzi said the roller coaster move in prices is destructive for the oil industry and is leading to investment cuts that may store up serious trouble for the future. "What we need is stability: a central bank for oil. Prices could jump to $150 or even $200 over the next four or five years," he said.

Khalid Al Falih, president of Saudi Aramco, the world's biggest oil producer, said the mix of financial leverage and the end of quantitative easing had "accelerated" the collapse in prices but the slide has lost touch with reality. "We're going to see higher demand this year. Investors are shaken and will now be more careful about committing money to mega-projects in the oil and gas industry," he said.

Fatih Birol, the chief economist for the International Energy Agency, said the dramatic crash since June has been caused by a unique set of events. Supply surged by 2m barrels a day (b/d) last year - the highest in 30 years - at exactly the same moment that China slowed sharply, Japan fell back into recession and Europe's recovery stalled.

"Oil at $45 is a temporary phenomenon, so don't get too relaxed. We see upward pressures on prices by the end of this year. Oil investments are going to fall by 15pc or about $100bn dollars this year," he said. Mr Birol said this could combine with a jump in demand to create a much tighter market later this year.
Russia's deputy prime minister, Arkady Dvorkovich, said the bottom is in sight. "Oil is not going to go to minus $40. There is a level where it will stop and that is not far away. It's close," he said.
For now his country is gritting its teeth, relying on its reserve funds to plug holes in the budget and cushion the downturn. "We are not going to cut the budget by half, but by 10pc to 15pc," he said.
"We will use our reserves for the priorities that are most important. For this quarter, the stability of the banking sector is key," he said.

Mr Dvorkovich did not dispute warnings from the International Monetary Fund that Russia's economy will contract by 5pc this year and is now in grave crisis. "At interest rates of 17pc it is impossible to do any business in Russia. We have extreme inflation and we have to reduce it, but if there is no real trust in the policies, inflation will go up whatever you do," he said.

He said oil prices have been pushed below their "equilibrium level" deliberately for political reasons, hinting that $70 to $80 would be the non-political price in today's market. "There are governments that don't want to reach that level yet, the Saudi government as well," he said.

Opec's Mr Al-Badri denied vehemently that there was any political motive behind its refusal to cut output. "This is not directed against US tight oil, and not directed against Russia. It is a pure economic decision," he said.

Mr Al-Badri said Opec had kept production steady at 30m barrels a day for a decade, while non-Opec states and US shale had added 7m barrels per day. "Why should low cost producers cut their output to make way for high cost producers? It doesn't make any sense," he said.

The Beauty of Deflation

By: Claudio Grass
Thursday, January 22, 2015
The Eurozone has been hovering around a 1% inflation rate, getting closer to zero during 2014, nothing close of the ambitious 2% benchmark set by central banks. Any small downward adjustment in the inflation rate will put it in the negative territory, allowing for prices to spiral downward. The West is genuinely fearful of deflation. Headlines in leading papers were very strong in reflecting this fear, describing deflation as "the world's biggest economic problem", or the "nightmare" that stalks Europe that will lead to its "descent" and collapse.

The real question is why do our governments fear deflation? Why do they perceive it as the chronic disease that could infect our economy and why do they go to such great lengths to avoid this "taboo"? The mainstream argument says we should avoid deflation because it causes a drop in overall demand and lower growth (Germany and other European states have been living a slowing recession recently which called for a downgrade in 2014 growth expectations).   

Also, deflation implies a decline in prices, lower corporate earnings and asset values, particularly real estate.

But the greatest concern to governments is not deflation itself; the real concern is the impact of deflation on the already over-indebted economies of Europe. Seven of the Eurozone countries are projected to have public debt to GDP ratios of over 100% next year! The worry is quite legitimate as Europe is on the verge of a debt-deflation spiral. With deflation, the burden on the already highly indebted governments increases making a default even likelier. So what are policymakers doing to "tackle" this problem?

As always, policymakers opt for the easy way out. Interestingly enough, they expect a turnaround of "fuelled" growth in 2015, driven by ECB President Mario Draghi's quantitative easing (QE). QE means there will be more money printing that will increase the overall debt even further. Instead of questioning the methodology itself, analysts expect an impact from this policy. The ECB's current priority is obviously to stimulate growth the American way: facilitate bond purchases with newly created money. On its website, the ECB states: "In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation." Unfortunately, all this means is that the ECB is convinced that monetary policy is not enough, and believes in further interventionist measures to avoid deflation at all costs. The direction that the ECB has taken throughout this year strongly reflects this - the negative interest rate is one of them. But really how negative will the interest rate go? Mr. Draghi has asserted his commitment to consider all available options to redress threats of deflation, including structural adjustments - but these are too time consuming. The easy way out is more debt and more printing of money.

The delusion that is inflation

Before he was Chairman of the United States Federal Reserve, Ben Bernanke claimed in 2002 that "...sufficient injections of money will ultimately always reverse a deflation". Unfortunately for Bernanke, the Japanese cannot argue in favor of this opinion. Deflation was not unfamiliar to Bernanke. Japan went through a decade of deflation since the early 1990s and it has been "trapped" there since, not because of deflation itself but rather because it chose to redress deflation mainly by reflating the economy. It even implemented its QE program back in 2001 but with mixed results. It is living proof that monetary easing only perpetuates the "crisis" and does not repair the damage. So why go through that road again?

The Austrians say deflation plays a major part in the inevitable bust

Bernanke himself said that deflation is feared because it increases the real value of debts. Truth is deflation accentuates money, or rather the value of money. We believe that it strips all the excess nominal value added in the price of a product, making it reflect its true value and worth. Therefore we ask why the fear from deflation? In our view and as highlighted by the Austrian School economists: the bust is inevitable. The bust allows for the market to correct itself. Intervention in the economy, particularly through monetary expansion will only prolong the time span until the bubble bursts, and it will be more severe the longer it is delayed. Yes, we see there is a beauty to deflation.

There is no one that could agree more than Austrian School economist Jörg Guido Hülsmann, a senior fellow at the Mises Institute and Professor of Economics at the University of Angers in France.

Over the years, Hülsmann has made great contributions on this topic. To Hülsmann, deflation is our savior - this is no exaggeration. As he said: "We should not be afraid of deflation. We should love it as much as our liberties." Deflation goes hand in hand with releasing the individual from the enslavement that was created with the monetary policies in the past 100 years. The unlimited printing of money we've seen over the years became an orthodox strategy to avoid deflation. In fact, Hülsmann argues deflation became the scapegoat of 100 years of pro-inflation propaganda!

Austrian economists such as Mises and Rothbard did not show strong opposition against pro-inflation propaganda. According to Hülsmann, Mises and Rothbard "championed deflation only to the extent it accelerated the readjustment of the economy in a bust that followed a period of inflationary boom."

Rothbard may have discussed the topic more so as he argued that deflation has a beneficial role in speeding up the readjustment of the productive structure after a financial crisis. But clearly, deflation plays a great part in the readjustment of the economy to its natural equilibrium. Mises is quoted as saying:
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
Deflation reinstates our lost liberty

Hülsmann builds on Rothbard's work, and his views are strongly and absolutely against inflation mainly due to the intervention of government in the economy. In other words, for deflation to happen means that government has no business in the economy. Anything short of laissez fair, such as structural adjustments or reforms, means the government is still in control. But how did inflation endorse state intervention and thus lead to the loss of our liberties?
  1. Unlimited printing of money to support the welfare state created a sense of dependency of the individual on state services.
  2. The expansionary monetary policy led to an exponential increase in public and private debts making the individual constrained by the burden to repay his loans and financial commitments.
  3. The debasement of currency and loss of value has led the individual to opt for debt instruments and debt-related financing measures to increase income.
  4. Inflation has led to unfair and unequal redistribution of wealth. The few that exist in the form of financial and monetary authorities and their acquainted banks and financial institutions get to benefit at the expense of the general public.
  5. Inflation redirects money into refinancing debt facilities and away from investing in production capacities, making the state (and its citizen) tied into a never-ending spiral of debt.
We truly believe that the endorsement of deflation goes hand in hand with safeguarding liberty.

Does this sound extreme? Dramatic? But it is true. Monetary history shows that in the 19th century individuals were "sovereign". During the gold standard, individuals were free from debt and enjoyed independence due to what is known as "sound money".

Precious metals safeguard independence and liberty

"Paper money has become the technical foundation for the totalitarian menace of our days."

We can't but agree with Hülsmann on this. Paper money, inflation, and debt all are ingredients of this political project, only to benefit a certain strata of society or "political entrepreneurs" as Hülsmann calls them, at the expense of individual liberties and independence. In fact they have every right to be afraid.

Deflation strips them from the benefits they have reaped at the expense of the rest of society.

We argue that deflation liberates us. Deflation will redistribute wealth by modifying the structure of ownership and thereby ensure distributive justice. The drop in prices and the quantity of money will reinstate the true value of currency and thus true wealth of states and persons. Deflation will put an end to the individual's dependency on debt structures and therefore promote focus on enhancing production. The determinant of wealth is not found in the quantity of money but the factors that drive it, namely productivity and innovation. We firmly believe that gold and silver are the sole currencies that will safeguard independence and liberty. They reflect true value, a store of wealth and safeguard the sovereignty of nations and individuals!

We do not know what the future entails when our existing monetary and financial systems break down, but we are convinced that gold and silver will offer security (at least) in the transition period. If we look at the gold purchases by the East, it also reveals how emerging markets have set their minds on gold. This further supports our conviction that a form of gold standard might regain a prominent status and take over once again. However, the prevailing monetary experiment called "fiat currency" is likely to persist for some time to come.

Read This, Spike That

Can U.S. Stocks Stay Hot As Global Markets Lag?

Several articles question the notion that the U.S. economy will keep stocks insulated from overseas woes.

By John Kimelman           

January 21, 2015

One popular narrative parroted constantly in the financial media in recent weeks is that the U.S. economy is in a class by itself.
As the thinking goes, this economic version of American exceptionalism should redound to the benefit of domestic stocks with limited exposure to weak foreign markets.
But as the U.S. bull market begins to sputter a bit after last year’s strong climb, some are rightly questioning this jingoism.
Writing for the Website of Pension Partners, a money management firm that focuses on asset allocation, research director Charlie Bilello takes on the idea that “the U.S. is strong and is an island onto itself.”
To be sure, the U.S. stock market has been besting its global peers over the past half decade. “Five years of outperformance is a long time and enough to build a strong case for just about anything,” concedes Bilello.
That aside, the economic warning signs for the U.S. is existing alongside the recent news that the U.S. economy grew at a 5% clip in the third quarter amid falling unemployment.
He is troubled by falling inflation expectations and a flattening yield curve, which can be signs of economic trouble.
Also, “like Europe and Japan, U.S. long duration yields have plummeted over the past year. The 30-year Treasury yield is at a new all-time low, below the crisis lows of 2008,” Bilello writes. “Credit spreads in the U.S. are widening,” he adds, “with the high yield index showing a 542 basis point spread, up from 388 basis points one year ago and 335 basis points last June.”
He also notes that within the U.S. stock market, it is not the cyclical (or economically sensitive) sectors but defensive sectors such as Utilities, Health Care, and Consumer Staples that have been outpacing the Standard & Poor’s 500 since the beginning of 2014. Clearly, Mr. Market isn’t rewarding stocks primed for an economic surge.
“Collectively, these factors suggest that the U.S. is not immune to a global slowdown,” Bilello concludes, adding that his firm’s asset-allocation strategies “remain defensively positioned.”
Meanwhile, Jim O’Neill, the former chairman of Goldman Sachs Asset Management and a columnist with Bloomberg View, is openly questioning whether “the U.S. economy can keep its balance.”     

“On the one hand, if the dollar were to strengthen in 2015 as it did in 2014, there’d be a boost to consumer demand from higher real incomes, and this would support the recovery,” he writes. “On the other, the diminished competitiveness of U.S. producers in domestic and foreign markets would probably cancel out the benefit. Exports would fall and imports would rise. It’s quite likely — contrary to some short-term forecasts — that the combination of cheap oil and a strong dollar will be more helpful to Japan and the euro area than to the United States.”
O’Neill writes that if he were a Federal Reserve governor, he would be concerned enough by these conditions to wonder whether the dollar’s strength “in effect, an unplanned tightening of U.S. monetary policy -- should make me want to postpone the first post-crash rise in short-term interest rates.”
Doug Kass, the president of hedge-fund shop Seabreeze Partners Management and a ubiquitous market pundit, is also wondering about the supposed moat that keeps the U.S. insulated from economic problems in Europe and Asia.
“The notion that the U.S. will be an ‘oasis of prosperity’ seems an unlikely outcome in a networked, interconnected and flat world,” he writes in a blog post appearing on Yahoo! Finance. “Commodities, currencies, interest rates and our capital markets are linked together to the degree never seen in history.”
As a result, Kass is playing defense and erring “on the side of conservatism as the potential for a market correction looms. I continue to favor above-average cash positions.”
In a useful piece for Morningstar, Christine Benz, the site’s director of personal finance, took a look at what some of the best “go anywhere” fund managers are doing with their money. She looked at Morningstar medal-winning global asset allocation funds managed by the likes of BlackRock and GMO, the Boston-based company headed by Jeremy Grantham.
What she learned is that many funds are pushing up their weighting to cash and underweighting U.S. stocks, which they view as overvalued. “The fact that many of the medalist world-allocation funds employ valuation-conscious strategies has also contributed to fairly light stakes in U.S. equities as they’ve rallied,” she writes.
So much for American exceptionalism in the markets.