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Mike Holt is a Senior VP, Wealth Management Strategist with The MDE Group, an innovative Wealth Management Firm located in Morristown, NJ that manages over $1 billion for corporate executives and other high net worth individuals located across the US. Mike's diverse background includes auditing... More
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  • A Quick History: Reaching Stable Disequilibrium 12 comments
    Feb 28, 2011 11:25 AM

    In my previous article, I indicated that higher food prices and unemployment were an important catalyst for the recent political unrest in parts of Africa and the Middle East, and that I believe we are likely to witness in other parts of the world as well. I then asserted that higher food prices and unemployment have been driven, in part, by deeper currents whose relevance may not be obvious.


    Clearly, rapid growth in highly populated countries such as China and India will exert upward pressure on global prices for resources. What may be less clear is the extent to which increased market intervention by governments and central banks around the world is exacerbating these pressures. Let’s take a step back to put this into better perspective.


    To really do this topic justice, it would help to go back to the origins of money, as Niall Ferguson does in his book, “The Ascent of Money: The Financial History of the World,” or to analyze financial crises over a period of many centuries as do Carmen Reinhart and Kenneth Rogoff in, “This Time is Different: Eight Centuries of Financial Folly.”  For now I will take you back only to the nineteenth century, when the US economy was primarily agrarian and subject to strong seasonal trends in the supply and demand for money, which consisted of thousands of different currencies created by an equal number of banks chartered at both the federal and state levels.


    This was a confusing state of affairs, and waves of bank failures and/or scandals only made matters worse. The U.S. clearly needed a single currency, increased regulation, and a lender of last resort to help banks cope with the seasonal demand for bank loans and deposits.  However, the creation of such a central bank was controversial for two important reasons:


    1. Americans feared that our founding principles of liberty and justice would be jeopardized if too much power was consolidated in a centralized organization; and


    1. Our Constitution provided the government, not private bankers, with the right to coin money but was silent as to the right to print money – or, more importantly as it turned out, to create money. So, if a central bank was created, it was not clear whether it would be controlled by the government or by private bankers.


    Amidst this controversy, the Federal Reserve was created in 1913. It is not a government agency, but rather is owned by private sector banks.  It was organized to consist of twelve Regional Federal Reserve Banks subject to the governance of a Federal Reserve Board in Washington, DC, in order to give it the appearance of both decentralization and a balance of power between the government and private sectors. The Federal Reserve Act also gave the government the power to print money, but the power to create money was vested with the Federal Reserve.  To conform to our Constitution, the money that the Federal Reserve decides to create is, in fact, printed by the government through the Bureau of Printing and Engraving.


    Putting aside these long-forgotten controversies for the moment, the creation of the Federal Reserve did, initially, allow banks to more readily adapt to fluctuations in market demand for loans by borrowing additional funds from the Federal Reserve using as collateral the same commercial paper that had been pledged to them by their borrowers.


    However, WWI broke out shortly after the Federal Reserve was created, and after the war the government found itself in debt. Although modest relative to the mountains of debt that have been accumulated since that time, the government was anxious to keep the interest rate on that debt as low as possible. Therefore, in 1918 it modified the Federal Reserve Act of 1913 to allow banks to also pledge government securities as collateral for the loans that they sought from the Federal Reserve.  In addition, the banks would be permitted to borrow from the Federal Reserve at a lower rate if they pledged such government securities as collateral rather than commercial paper.


    Since banks back then were still in the business of making loans, and they could generate larger profits from these loans if amounts available for lending could be borrowed from the Federal Reserve at a lower interest rate, demand by banks for government securities quickly soared.  Almost as quickly, the Federal Reserve learned that the terms at which government securities were made available to banks could influence their lending behavior by even more than fluctuations in the demand for loans by private sector borrowers based upon natural market forces.  In other words, a relatively small group of individuals could now exercise tremendous control over the economy simply by manipulating the supply and demand for government securities rather than acting merely as a “lender of last resort” responding to fluctuations in private sector demand for loans and deposits.  This was the genesis for what are now known as “Open Market Operations,” which we take for granted as being an important and necessary monetary policy tool available to the Federal Reserve.


    Putting this newly acquired power to work, primarily under the influence of a single member, namely Benjamin Strong, the head of the New York Regional Federal Reserve Bank, the Federal Reserve coordinated its activities with central banks in England, France, and Germany to restore the gold purchasing power of the British Pound to its pre-World War I level. This was achieved by causing interest rates in the United States to remain artificially low, so that cash available from other parts of the world would flow to England rather than the US in order to earn higher interest rates, thus bidding up the value of the British Pound in the process. These policy decisions obviously had little to do with the natural forces of market supply and demand, but it was hoped that this return to the status quo would somehow stabilize the world financial system.  The low interest rates and easy money policies being pursued in the US did, in fact, lead to a robust period of economic growth known as “the Roaring Twenties.”  But, the price to be paid for resisting natural market forces was excessive debt and a stock market bubble.


    In response, rather than allowing the economy and financial markets to achieve a true state of equilibrium, additional market-distorting government and central bank interventions were introduced instead. These shifting, sometimes contradictory policy decisions and interventions created confusion and uncertainty, which wreaked further havoc on the economy and markets for over a decade. In effect, the growth and stability of our economy became increasingly subject to the policy decisions of the federal government and the Federal Reserve, rather than the direct market forces of supply and demand operating within the private sector.  However, a more “stable disequilibrium” was eventually achieved, subject to the “mere” expense of growing mountains of debt, and increased reliance upon the centralized policy decisions taken by an increasingly powerful federal government and “Federal” Reserve.


    These growing debt levels could not even be kept in check by using American workers’ social security retirement plan contributions to temporarily reduce outstanding US Treasury obligations that had been issued to the public. This is explained, in part, by the eagerness of export-oriented countries such as Japan and the East Asian Tigers (Taiwan, Hong Kong, South Korea, and Singapore), to acquire our debt along with many OPEC-member countries. So, in effect, the growth and stability of our economy became increasingly subject not only to the policy decisions of “our” federal government and “our” Federal Reserve, but also to the policy decisions of foreign governments and foreign central banks.


    Nonetheless, for decades, most Americans seem to have been lulled into the belief that these growing debt levels “didn’t matter” as long as our GDP grew faster. Unfortunately, little attention was given to the composition of our GDP, in particular the erosion of our manufacturing base and the growing percentage of GDP attributable to consumer spending.  More importantly, little attention seems to have been given to the possibility that economic growth, in percentage terms, may not persist at the same levels as it had before, when our economy was smaller, less fully developed, and less subject to more serious competition from other countries. If the growth rate of our economy falls below the growth rate of our debt, the burden of this debt would increase. As many individuals with excessive credit card debt at rates high above their initial teaser rates can now attest, these liabilities can spin further out of control when rates rise.


    Faced “suddenly” with the realization that new debt would soon have to be issued to raise the funds needed to return social security retirement plan contributions to aging baby boomers, and that decreased spending by these aging baby boomers could simultaneously serve to slow economic growth, it gradually became clearer to more and more people that something would need to be done to ward off soaring debt-to-GDP ratios. The two primary choices are:


    1. Reduce the debt; and
    2. Increase economic growth.


    Austerity measures have proven themselves to be unattractive ever since the federal government and Federal Reserve were initially faced with this conundrum in 1929, and less spending means a smaller government. So, predictably, the latter alternative has been given priority.


    Unfortunately, no other age group spends as much as 45-year-olds in their peak earning years. Furthermore, some of the more astute policy makers have observed that it could take as long as 45 years to make new 45-year-olds. Some have even speculated that the disproportionately large segment of the US population known as the Baby Boom generation might even reduce their spending in order to save for their retirement, or “worse” yet, to actually begin to tap their retirement nest eggs.  That could put downward pressure on the value of investment assets, which is of particular concern because many leveraged banks rely on the value of these assets to collateralize their loans, as well as the leveraged investments held by their proprietary trading departments.  So, without jeopardizing their popularity among voters, at least not within their terms of office, policy makers have finally conceded that something must be done about these inherited problems.  It just isn’t clear what that something should be, and who should be held accountable.


    Tragically, in the midst of these deliberations, the US suffered terrorist attacks on the Pentagon and the World Trade Center on 9/11/2001.  The impact that further terrorist threats could have on our already slowing economy at the time was not at the top of the list of priorities to be addressed, but it was not completely overlooked either.  This risk of further terrorism was thought to be magnified by the existence of poverty, and a lack of opportunity particularly among youth populations in countries most subject to the influence of terrorist groups.  So, increased emphasis was placed on providing aid to impoverished countries, and the US obviously stepped up its presence in the Middle East, among much controversy.


    However, another event that took place at that time is often overlooked.  When reference is made to the eleventh day of a month in 2001 that marked a turning point in history, few people are likely to think of 12/11/2001, which was the day that China was admitted to the World Trade Organization. Yet, that event has profoundly changed the world, and has much to do with the unrest that we are now witnessing in a number of poor countries, including, but not limited to, those in the Middle East.  That will be the topic covered in my next article.

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  • jake333
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    Your explanation of the monetary policy actions coordinated among central bankers during the Roaring Twenties is interesting, but I’m trying to reconcile your comments with those of Liaquat Ahamed in his essay published in the March/April 2011 issue of Foreign Affairs.


    You seem well informed, so I’m sure you recognize Liaquat Ahamed as the author of “Lords of Finance: The Bankers Who Broke the World,” which won the 2010 Pulitzer Prize for History. His book focuses on the actions taken by central bankers in the US, England, France, and Germany at that time. However, it also delves into their sometimes peculiar personality traits, which can obscure the discussion of the monetary policy decisions made by this small but extremely important clique. That’s why I found Liaquat Ahamed’s essay in Foreign Affairs, titled “Currency Wars, Then and Now: How Policymakers Can Avoid the Perils of the 1930’s to be helpful.


    In this article, Liaquat Ahamed argues that policies in the two biggest economies in the world at that time, the United States and the United Kingdom, seemed to be aimed at getting themselves moving at the expense of the economies in Europe. However, he focuses on the policy decisions made by this small cadre of individuals during the 1930’s rather than the 1920’s. He also suggests that the imbalances that led to the excesses of the 1920’s, including the stock market bubble, resulted more from the fact that “The major European nations, having spent some 50% of their GDPs on the war effort for four full years, were left saddled with gigantic debts and were able to recover only by borrowing from the United States. Washington, meanwhile, emerged from the conflict with a very strong external position, having accumulated over 50% of the world’s gold reserves.” He goes on to say that “Because domestic money supplies were rigidly linked to gold reserves, those countries accumulating reserves would automatically experience easy credit, strong demand, and rising prices.”


    So, regarding the easy money policies in the US during the 1920’s, was this due to the fact that the US was still on the gold standard, or was it due to the policy decisions of a very few central bankers? Liaquat Ahamed seems to suggest that the “Lords of Finance” didn’t mess things up until the 1930’s.
    2 Mar 2011, 04:50 PM Reply Like
  • Mike Holt
    , contributor
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    Author’s reply » Jake, thanks for your question. I saw Liaquat Ahamed's essay in the March/April issue of Foreign Affairs magazine. I would suggest that you also read the essay immediately following it by Raghuram Rajan titled "Currencies Aren't the Problem: Fix Domestic Policy, Not Exchange Rates." I can delve into this in more detail at a later time, but for now let's not get too deep into the weeds. Doesn't the fact that decisions regarding issues affecting millions of people across the country -- indeed, across the world -- are impacted so heavily by a handful of individuals with little transparency into what really matters strike you as being a bit unusual. In politics, we learned over the past century what happens when too much control vests in a single individual. That proved to be a mistake no matter when we allowed it to occur. Why would decision-making authority of something as important as the power to create money be so different. Think about that: the power to create money. That is an awesome power, and it doesn't fall within our three branches of government. The President has the power to appoint the chairman of the Federal Reserve, but who owns the Federal Reserve, and how much concern have they shown for the American public lately?
    6 Mar 2011, 05:39 PM Reply Like
  • Mike Holt
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    Comments (1869) | Send Message
    Author’s reply » The debate whether to raise the debt limit was nothing more than political theater. I was surprised that it turned into Kabuki Theater, but nonetheless the reality is that there are many levers that may be pulled to circumvent the constraints imposed by the debt limit. See the latest (7/1/2011) annual Congressional Research Service Report titled "The Debt Limit: History and Recent Increases" for a summary of the tactics that have been employed in the past to find ways to continue spending -- and borrowing. So, in the end, after all was said and done, there was -- you guessed it -- a lot more said than done.


    However, one thing that this debate over the debt limit has made clear is the importance of available financing to the government. Luckily, it was only an internal circumnavigable rule that caused the restriction on borrowing, but it demonstrated what could happen if lenders were to refuse to continue financing us at the same teaser rates that we have been enjoying. Global power is increasingly dependent upon economic strength rather than military might.


    In the words of Mayer Amschel Rothschild,


    "Give me control of a nation's money
    And I care not who makes the laws."


    As I have indicated elsewhere, the US Constitution gives government the power to COIN money, and the 1913 Federal Reserve Act gave government the power to PRINT money, but the 1913 Federal Reserve Act gave the Federal Reserve the power to CREATE money. Think about this: the power to create money. What an awesome power. Yet, the Federal Reserve is not one of our three branches of government, so it is not subject to the checks and balances intended to prevent too much power from accumulating into the hands of too few. Congress doesn't even have transparency into the Fed's critical dealings -- although it is now imminently clear how carefully our government listens to those who control its purse strings.


    But, why has government debt been allowed to continue spinning out of control? Bond vigilantes haven't bid up borrowing rates because there is so much capital sloshing around. OPEC and Asian exporters prefer to direct proceeds from their exports into US Treasuries, agencies, and other US dollar denominated assets, rather than into the hands of their own populations, for various reasons. And, bear in mind that fiscal conditions in many other developed countries are even worse. So, the US Government's borrowing rates remain artificially low for now, like the teaser rates on mortgages and credit cards taht nobody could resist, until things suddenly changed.


    So, without the bond vigilantes, voter vigilantes have emerged in their place. They are primarily worried about the fact that the present value of unfunded US liabilities already exceed the $58 trillion total net worth of US Households as of 12/31/2010 (including the balance sheets of non-profit organizations). But, the recent debt limit debate reveals that many other voters think that more debt means more government handouts that "the rich" will be capable of paying, so they claim that those trying to fend off a debt crisis are mean spirited, and the real "bad guys." No wonder the issue of entitlement reform has been considered as the "Third Rail" of politics for so many decades -- and ignored, accordingly.


    I, too, would like to have my contributions to the government administered retirement plan known as Social Security returned to me, someday, even if I have to pay income taxes when my funds are returned to me. However, if the US government does not begin taking steps now to strengthen its balance sheet in anticipation of these future liabilities, that is more likely to jeopardize my receipt of the amounts that I am owed, rather than making their receipt more likely.


    But, as both an investor and as an American citizen, I am at least as concerned about the growing role of government and central banks in the economy. It's no longer possible to formulate an outlook for the markets and the economy without asking what actions may be taken by Bernanke, Obama, OPEC, the Chinese Communist Party, Putin, Trichet, Merkel, the IMF, etc. Free market competition has taken a back seat to politics as governments and central banks around the world have taken control over the Commanding Heights of their economies. In the words of Ian Bremmer, Nouriel Roubini, and Muhamed El-Erian, welcome to the new "G-zero" world and the "new normal."


    As more and more power is consolidated and centralized, it seems ironic that the biggest threat to "the little guy" has become "other little guys" whose votes can be counted upon to keep Big Banks and Big Government in power by increasingly subjecting them to their "mercy." Maybe if all the little guys learn to trust each other we can get ourselves back on the right track. After all, "Civilization is built upon trust; and trust upon the integry of each individual." But, in the meantime, investors should not expect significant reductions in government debt anytime soon.
    2 Aug 2011, 02:26 PM Reply Like
  • Economic Analyst
    , contributor
    Comments (3852) | Send Message
    Great insight, I'm glad I found your article. Thanks for the education.
    3 Aug 2011, 03:49 PM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » Standard and Poors' decision to downgrade the credit rating of US debt has been criticized for three reasons:


    1. Assumptions: Their analysis assumed that the government's discretionary spending would be higher than what the government has projected it to be;


    2. Tiiming: Standard and Poors issued it's downgrade within 2 hours of the debate over whether future discretionary spending assumptions should alter the credit risk associated with US debt within a 3 to 5 year context; and


    3. Credibility: Why should anyone pay attention to Standard and Poors since they failed to alert investors to the credit risks associated with Mortgage Backed Securities a few years earlier?


    1. Standard and Poors has explained that existing US debt is already too high and meaningful reductions are required in order to provide investors with an AAA level of confidence that this debt will remain manageable. The recent decision to reduce debt levels only modestly, and the manner in which this decision was reached, did not restore confidence in the government's ability or willingness to take the steps that Standard and Poors previously advised would be necessary in order avoid a credit downgrade that the agency warned about months ago. In other words, projected levels of discretionary government spending 20 years from now did not play a significant role in Standard and Poors' assessment of the credit quality of US debt over the next 3 to 5 years. The apparent inability and unwillingness to take actions today played a much more important role. The market's reaction to these same concerns earlier this week were entirely consistent with Standard and Poors assessment.


    2. As to why Standard and Poors did not allow the red herring issue raised by the government to indefinitely postpone their 3 to 5 year credit outlook -- to kick the can further down the road, so to say-- I would think the better question to ask is why the credit rating agencies didn't raise concerns about the manageability of the large and growing US government debt levels decades ago. As an aside, I would also point out that the timing of Standard and Poors announcement may prove to reduce global financial market instability in that investors may now be less inclined to flee European debt markets in favor of US Treasuries that investors otherwise may have been led to believe were much safer.


    3. Recent developments, or the lack therof, obviously support the decision by Standard and Poors to stand behind it's decision announced months ago to reduce the credit rating for US debt unless immediate actions of a sufficient scale were taken. Standard and Poors made it clear that their rating would be based upon the clarity of plans to address burgeoning debt levels backed by immediate actions to demonstrate that these plans have any substance. How could the government think that investors should be contented instead by divisive rhetoric about ideaological issues to be endlessly debated by future commissions formed to study obvious problems after the next election? The markets, and Standard and Poors have spoken -- and taken action. Why have the other credit rating agencies not followed suit? Does their continued unwillingness to independently and objectively express their views somehow make them more credible? Do they have greater competence than Standard and Poors, or do they still fear reprisals from those whose credit risk they are supposed to be evaluating? That is their raison d' être so should they not at least be stating their reasons why they believe that US debt continues to deserve a AAA credit rating even when the markets -- or at least what's left of them -- seem to believe otherwise. I believe that Standard and Poors has demonstrated that they are the only institution with any credibility left.
    6 Aug 2011, 12:00 PM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » US loses AAA credit rating from S&P [View article] If a car is about to drive off a cliff, does it really matter if it's broken speedometer says the car is only going 79 miles per hour rather than 87 miles per hour? The bond vigilantes either aren't sure or they are outnumbered by the bad guys who can't wait to pick up the pieces. The voices of the voter vigilantes are being drowned out by the voices of other voters at the bottom of the cliff who think they're about to get a new car for free. But, now stock market vigilantes have rode into town, followed by a new sheriff who calls himself Standard & Poors. The town is empty because all the heads of state are at the beach. "Earth to politicians, come in politicians..." they call.


    Hmmmm, perhaps they can now be reached only through one of those "red machines" given only to members of the Chinese Communist Party. Or perhaps it would help if we turn up the volume. "Can you hear me now? Can you hear me now?". Hmmm, if the stock market falls in the middle of my question, does anybody hear it?
    7 Aug 2011, 10:45 AM Reply Like
  • Economic Analyst
    , contributor
    Comments (3852) | Send Message
    "Clearly, rapid growth in highly populated countries such as China and India will exert upward pressure on global prices for resources. What may be less clear is the extent to which increased market intervention by governments and central banks around the world is exacerbating these pressures."


    It seems the two most commonly used control levers are money supply and interest rates, and it is adviseable not to use both at the same time.


    Is it possible that inflation is the answer to where resources should be applied, and that using interest rates as a brake on the economy is an outdated notion, as market forces if left to run their course will create the necessary incentives to create supply where material shortages exist??
    7 Aug 2011, 11:53 AM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » EA, I wrote some commentary that addresses this topic but it was lost because my computer crashed before they were published. I am attempting to recreate what I wrote and the first half is reflected below. The second half deals more directly with your questions/concerns.


    In the meantime, money supply and interest rates are two sides of the same coin. The other policy lever is fiscal policy, and the combination of the two is known as the policy mix. The Canadian economist Robert Mundell was awarded a Nobel Prize for his research on this and related topics. Although Arthur Laffer is more widely known Mundell played a greater role in the development of supply side economics.


    Having said this, I believe it is a mistake to intervene too heavily in the markets, and I think governments and central banks have placed too much reliance on these measures rather than addressing more fundamental issues that are more at the heart of our problems. It's as if they are trying to win a football game by tinkering with the scoreboard rather than paying attention to what's happening on the field. Stay Tuned.
    8 Aug 2011, 08:14 AM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » If nothing else, the recent announcement by Standard and Poors that it has decided to reduce the credit rating for US government debt below AAA status has sparked a long overdue, healthy debate regarding government debt levels in general, and in the US in particular. In this regard, I would like to clarify some important issues and misconceptions regarding government debt.


    1. “Gross Public Debt,” which is sometimes also referred to as Total Debt, does not equal total debt. What? Let me explain: What the US reports as “Gross Public Debt” is made up of two pieces. The first piece is “Public Debt” which represents debt currently outstanding to the public. That seems pretty simple and straightforward – although it has grown to an astounding $9.78 trillion as of August 3, 2011.


    The second piece of Gross Public Debt is government liabilities for future payouts to which it has obligated itself (taxpayers actually), AND for which it has received funds that were used to pay down existing debt owed to the public. In other words, the second piece represents intra-government IOU’s in lieu of currently outstanding debt instruments held by the public. These are sometimes called “funded liabilities” to cover future obligations such as Social Security retirement benefits, Medicare benefits, and government/military pension benefits. However, this is somewhat misleading, since the cash already collected to fund these future payouts is not held in what Al Gore used to refer to as a “government lock box.” Rather, cash received has been used to repay outstanding Treasury instruments, and the IOU’s created to record such debt retirements ultimately must be replaced by selling new debt instruments to the public in order to raise the cash needed to fund the promised future payouts. The ability to issue new debt to the public on top of all the other debt piling up in the meantime raises some concerns, but at least this portion of the government’s future obligations has been reported.


    What’s missing from the “Gross Public Debt” figure (last reported at $14.34 trillion) is the present value of future government obligations for which no contributions have yet been received – and then diverted to other uses. Estimates vary as to the present value of these future liabilities for which no funding source has yet been identified, but David Walker, former U.S. Comptroller estimates the amount to be over $50 trillion. That’s on the low side relative to a study cited in the August 1, 2011 issue of Businessweek magazine that estimates what it refers to as the fiscal gap – i.e., the net present value of all future expenses minus all future revenue – to equal $211 trillion. Either way, the true present value of what the US government owes is far in excess of the $14.34 trillion Gross Public Debt figure that, by itself, raises questions as to its manageability.


    Granted, the government’s effective ownership of Fannie Mae and Freddie Mac may provide it with indirect access to assets that could be used to repay or collateralize debt in the future, but many of the homes that have been mortgaged are currently worth less than those mortgages. Moreover, the true present value of US government obligations already appears to exceed the $58 trillion total net worth of US households (including not just their homes but also their savings, private businesses, investment and retirement accounts, and all other assets, even assets held by non-profit organizations, e.g., charities), so the size and trajectory of US government debt is much more than just a political issue.


    2. Debt to GDP ratios in Japan are thought to be much worse than those for most other developed countries. However, Japan is a large holder of US debt. How can what appears to be a heavily indebted country serve as a lender to the US, and what are the implications, you might ask – or should ask. The answer is that much of the debt issued by Japan was used to finance purchases of US Treasury debt, since the interest rates that it receives on US Treasury obligations exceeds the interest rates that it must pay on Japanese government obligations that it issues. That’s because of a practice known as “financial repression,” meaning that Japan requires its citizens to direct a large portion of their savings into Japanese debt. The end result is an opportunity for Japan to earn interest from the US while it simultaneously subsidizes exports to the US by keeping the value of the Japanese Yen artificially low relative to the US dollar. If Japan were to liquidate large amounts of US Treasuries in order to fund redemptions of Japanese government debt, this could cause the value of the Japanese Yen to appreciate, which is something that Japan, with an export-oriented economy, would normally not prefer. However, in the event of a debt crisis, a strengthening of the Yen could be welcomed. This may also hold true for other countries that have amassed large amounts of US Treasury obligations and financed their purchase through the issuance of government debt subject to lower interest rates. The fact that an unwinding of these fixed income arbitrage transactions could come at the expense of higher US interest rates and/or an acceleration of declines in the value of the US dollar should be an additional cause for concern by Americans.


    3. It is difficult to compare Debt-to-GDP ratios in the US to Debt-To-GDP ratios for other countries because it is unclear whether the debt reported by those other countries similarly excludes huge amounts of “unfunded liabilities.” The resulting uncertainty may discourage investors and savers from fleeing the currency of any particular country in favor of another, for fear that the currency being issued by other countries is no more sound than their own. As such, the recent decision by Standard and Poors to reduce the credit rating for US government debt, after its recent reductions in the credit rating for various European countries, may create even further uncertainty that may roil the markets, but it might just fend off a potentially more disruptive flight of capital from other currencies. More optimistically, it might prompt government leaders in all heavily indebted countries to take more substantive steps to improve their fiscal health.
    7 Aug 2011, 05:59 PM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » The Debt to GDP ratio is one of the most commonly cited measures of a country’s ability to manage its debt. However, as indicated in some of my earlier comments, how much of a country’s actual liabilities are included in what it defines as its debt is flawed, making it difficult to make meaningful comparisons of Debt to GDP ratios for different countries.


    Putting aside the numerator of this equation for the moment, meaningful comparisons should also take into consideration the composition of a country’s GDP, i.e., the portion of its GDP comprised of consumer expenditures, government expenditures, and actual production. A country with a Debt to GDP ratio higher than that of another country may nonetheless be better able to manage its debt if more of its GDP consists of productive activities, especially if the country also generates trade surpluses.


    Other factors to consider include the existing net worth of households upon which the responsibility for government obligations will ultimately fall, unemployment levels, demographics, the ability of domestic companies to compete in global markets, and other measures of the country’s capacity for economic growth. Net immigration or emigration can also play an important role.


    In the US, efforts to manage its large and growing Debt to GDP ratio are being hampered by high unemployment levels, the aging of a disproportionately large segment of its population, a slowing economy, a declining manufacturing base, persistent trade deficits, a weakened financial sector, rising oil prices and a transportation sector that remains almost entirely dependent upon oil, costly military conflicts and homeland security programs, falling housing prices, rapidly increasing costs for health care and education despite growing concerns regarding their relative quality and effectiveness, a complicated tax code and increasingly complex regulations administered by a confusing array of overlapping regulatory bodies, and an increasingly polarized political system.


    Against this challenging backdrop, to the extent that the US has been willing to meaningfully address concerns regarding worrisome Debt to GDP ratios, it has chosen to do so by emphasizing economic growth. Whether this can be best achieved through lax fiscal policies, lax monetary policies, or both continues to be a hotly debated topic. After similarly lax enforcement of a myriad of regulations allowed a wide slew of participants in the housing and financial services sectors to inflict huge losses upon the rest of society, there have been a few arrests and a new set of more complex regulations especially burdensome to smaller competitors was enacted.


    Fortunately, some attention has also been given to the role of technology in economic growth and development. To appreciate this, witness the impact that technological advances have had on the rates of economic growth and development of particular countries. Among many other advances, these include the printing press, the industrial revolution, various forms of modern transportation, electricity, the light bulb, atomic energy, the computer, and the internet.


    Unfortunately, many of the new technologies being pursued today rely upon access to rare earth elements, and 97% of the supply of rare earth elements is sourced from China. As you may know, over the past few years, China has been reducing its quotas for exports of these vital materials. For this and other reasons, including the lure of access to its vast and growing market, many corporations have been shifting their manufacturing operations to China. However, China is also known for its lack of respect for intellectual property, and there have been many examples of companies being subjected to local content requirements after setting up shop in China. This means that these companies must purchase perhaps 70% of their component parts from local Chinese companies. That involves providing those companies with advanced training, and the exact specifications for critical components. The local Chinese companies then produce several times the requested quantities, and sell the remaining components to other local Chinese companies that, in some cases, have within a few short years become the dominant global competitor in that industry – in terms of market share and levels of employment, not necessarily in terms of profits and royalties from intellectual property that their foreign competitors must rely upon to stay in business.


    This can result in a decline in US employment, which is harmful to Americans in many ways. An obvious path to a solution would be to question the rationale for allowing China membership in the World Trade Organization, namely expectations that upon admittance it would quickly correct its serious deficiencies in the form of disrespect for intellectual property rights, human rights abuses, environmental degradation, and heavy government involvement that provides its state owned enterprises with significant advantages that tilt the competitive playing field heavily in their favor.


    However, as indicated above, US efforts to stimulate economic growth and employment have primarily been in the form of increased government spending and loose monetary policies. Given the free flow of capital, and attractive opportunities for US financial institutions to use low cost borrowings to make profitable leveraged investments elsewhere rather than loans to businesses and consumers here in the US, these government policies are just as likely to stimulate economic growth and employment in other countries.


    Some have argued that lax fiscal and monetary policies in the US will serve to reduce the value of the US dollar relative to the currencies of other countries, and that this, in turn, will fuel our exports. But, since China still maintains a de facto peg of the Chinese Yuan to the US dollar, these policies do little to make exports from the US more attractive relative to those from China -- although they have made exports from China even more attractive relative to those from other countries.


    So, how can the Fed’s quantitative easing programs be expected to reduce unemployment here in the US? An article titled “Globalization’s Critical Imbalances” that appeared in the June 2010 issue of the McKinsey quarterly, published by the consulting firm McKinsey & Co., offered a possible explanation. The article first identified three primary “factors of production,” namely:


    • Commodities
    • Capital, and
    • Labor


    It then posited that in order to avoid global trade imbalances, the global prices for these three factors need to be somewhat uniform, allowing for transaction and transportation costs. This theory, known as “the law of one price,” was first advanced by Adam Smith.


    Sophisticated global markets have evolved for commodities and capital. But, despite the popularity of overseas assignments, the internet, foreign call centers, and outsourcing in general, wide differences in labor costs throughout the world still remain. That is because labor has been, and is expected to remain, relatively immobile. It is therefore argued that the easiest way to achieve a uniform price for labor would be through foreign currency rate adjustments. In this way, the currency adjusted cost of labor to a multi-national corporation would be much more uniform.


    However, there would be obvious pitfalls to such an undertaking, including a loss in purchasing power for the citizens of the countries with higher labor costs – likely to be citizens of developed countries who worked to accumulate their wealth over many years. As such, even those who complain bitterly about the “inequality” of income levels in the US would likely object to the elimination of differentials between their wages and the wages of citizens in less developed countries if it meant the obliteration of their savings in the process. Although unemployment levels might be reduced, I believe that attempts to achieve such positive ends through artificial measures such as this serve to distort markets, not make them more efficient. Fair competition, with incentives for success, has been, and should continue to be, the means through which income levels are determined – with the operative word being “fair.”


    While unfair competition may lead to greater declines in costs for manufactured goods from State-Owned-Enterprises and heavily subsidized state champions, this must be weighted against the resulting increase in unemployment levels in countries damaged by such unfair competition. True, high unemployment levels minimize concerns about wage-push inflation, and that paves the way for misguided attempts to remedy unemployment and anemic domestic economic growth through artificial fiscal and monetary stimulus programs, but this just leads to absurd adverse feedback loops that cause wider and deeper problems.


    Debt-induced growth absent the discipline that higher prices would impose under a truly market-oriented system leads to growth levels that our planet earth can’t sustain, debt levels that weaken countries rather than making them stronger even if they serve to increase GDP – not necessarily the best or only measure of a country’s health, asset bubbles that provide only the illusion of wealth, and higher prices for raw materials such as food and energy. These higher food and energy prices may not be as significant to wealthier individuals, but they can be very impactful for consumers in developing countries – or the unemployed in more developed countries. And, any resulting social unrest could lead to much higher costs that debt-ridden countries simply couldn’t afford.


    This is why I refer to inflation and deflation as shadow risks, and why I view efforts to address the underlying problems primarily through increased government debt/spending and central bank intervention as being analogous to attempts to win a football game by jiggering with the scoreboard without even setting ones eyes upon the playing field. And, what concerns me just as much is the fact that these shenanigans lead to a growing concentration of power into the hands of central banks and autocratic government leaders ostensibly on behalf of the masses, but only ostensibly. The degree of control that we are able to exercise over our lives and our livelihoods is lost in the process.


    Watching our net worth fluctuate wildly as markets gyrate uncontrollably as a result of unknown but powerful forces reacting mysteriously to the vagaries of political actions that may or may not be taken in response to global macro risks that may or may not exist due to problems that are hidden by layers of smoke, mirrors, and accounting gimmickry is just the tip of the iceberg. Growing concentrations of power and control over both markets and the Commanding Heights of the global economy impose additional burdens that are less tangible, but no less real. In the words of the British historian Lord Acton “power tends to corrupt, and absolute power corrupts absolutely.”


    When America was founded, our forefathers recognized the truth in this statement all too well, and they had the courage to fight against such tyranny. That is why America was once regarded as the land of the free and the home of the brave, “with liberty and justice for all” -- rather than the land of the once almighty dollar. Our emphasis on shared principles above all else is what defines us as Americans, yet most of us can trace our roots to other countries. It should, therefore, be equally painful to us to witness those countries being ravaged by the burden of excess debt and the folly of additional debt, and increased government control, as the solution. So, as we grapple for solutions to the challenges immediately before us, we should ask ourselves whether the value of an additional dollar borrowed is worth more than the value of our principles, our heritage, and our freedom. Could this really happen? It may all depend on what the Federal Reserve, the ECB, Wall Street, OPEC, the Chinese Communist Party, or our own politicians in Washington, DC decide to do next.
    10 Aug 2011, 12:12 AM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » Let's take our hats off for Ben Bernanke, for a paragraph at least. In his speech today at the Jackson Hole symposium for central bankers sponsored by the Kansas City Federal Reserve, Mr. Bernanke announced that it is wrong to expect the Federal Reserve to take complete control over the global economy. He also acknowledged that high unemployment levels in the US must be reduced in order to improve the health of the US economy. "Most of the economic policies that support robust economic growth in the long run are outside the province of the central bank, Bernanke said.


    However, to resolve the unemployment problem, the Federal Reserve Chairman turned not to the private sector but to the government. I would agree that the government can play a role in reducing unemployment by taking actions to ensure that US companies can compete on a level playing field, but unfortunately, this does not seem to be the role for the government that Ben Bernanke had in mind. (You can put your hats back on, now.) Despite the slowing effects of increased uncertainty resulting from seemingly arbitrary government policy induced economic activity leading to artificial (and unsustainable) market conditions -- including credit market conditions spurred primarily by concerns regarding excessive debt levels -- Bernanke insists that reduced government spending would be a mistake while at the same time calling on Congress to adopt "a credible plan for reducing future deficits over the longer term" without harming US growth in the near term. While such a painless solution sounds good, it is not realistic, and pursuit of this illusory solution just sets us up for more pain in the future when there is no road left upon which to kick the proverbial can.


    Some claim that it is absurd for the government to reduce spending "at this time" but what is more absurd is to think that we can borrow our way out of debt. At what point does it become clear that excessive levels of debt are the problem not the solution? I don't hear anyone calling for increased spending by the Greek government to address the problems they are experiencing a bit further down the road, except for those relying upon government largesse for reasons motivated more by personal gain rather than efforts to identify practical solutions. So, how much more political and market upheaval is required before it becomes as obvious that the solution to the rampant debt problems here and in many other developed countries is not increased government spending and/or monetization of the resulting debt?


    It may be that debt levels have become so rampant in so many developed countries that the problem has been disguised; in relative terms, one country is not much worse than another, so no single country is punished because there is no better place for credit to flow or for savings to hide. But, we can't rely upon relatively equal levels of growing weakness forever. This is not a path toward a solution; this is a path toward an epitaph that reads "The problem was even bigger than we had thought."
    26 Aug 2011, 02:47 PM Reply Like
  • Mike Holt
    , contributor
    Comments (1869) | Send Message
    Author’s reply » Per the CNBC article linked below:


    "Japan's central bank concluded a two-day policy meeting today, arguably the most highly anticipated in years, with a commitment to double its government bond holdings in two years, adopt a new balance sheet target and combine two bond-buying schemes to allow it to buy government bonds of all maturities."


    "The Bank of Japan is doubling its balance sheet going from 130 trillion yen ($1.36 trillion) to 270 trillion yen by the end of 2014. The buying program goes right out to 40-year JGBs. It's going to trigger massive allocation shifts, and not just in Japan," Bill Blain, a strategist at brokerage Mint Partners, said in a note.




    This asset purchase program is about 75% the size of the Federal Reserve's program, and is being applied to an economy only 1/3 the size of the US economy alone. It may give new meaning to the term "stable disequilibrium."


    Concerns about global macro risks may have faded somewhat over the past few years, but announcements such as this have broad implications, and make it difficult for investors to focus primarily on bottom-up fundamental analysis of the companies in which they may choose to invest.
    4 Apr 2013, 12:23 PM Reply Like
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