Money velocity, not quantity, caused the boom'n'bust

Reading "Extreme Money", the acclaimed new book by Satyajit Das, has highlighted for me the importance of money velocity.

As Das so clearly demonstrates (pp. 78-80), the banks altered their mortgage lending model in recent years. Instead of lending money and then holding that mortgage to maturity, they would sell it on for a sum that included the discounted value of future interest payments. This returned bank capital and depositors' money more quickly, which made it available for a new loan. Turning the money over faster massively increased the ratio of net profit to bank capital, so that the yield on banking activities outstripped other, one might say more productive, forms of enterprise. It became almost the only game in town, so that the economy has been skewed towards sterile financial hocus-pocus, instead of providing and exchanging useful goods and services.

The system created a boom, which could only be sustained as long as borrowers could absorb the increased quantity of loaned money. Asset prices boomed as fools sold on to bigger fools, and poorer-quality borrowers were suckered into joining. But we seem to have reached the limit of this pyramid scheme, and having run out of expansion room, the velocity of money is dropping and attention then turns to quantity instead.

The question now being asked - again, since we are in the throes of QE3 - is whether pumping extra cash into banks will balance the equation. If Wikipedia (see "money velocity" link above) quotes him accurately, I think the answer was given more than sixty years ago, by Paul Anthony Samuelson:

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.

Banks have been given contradictory instructions: lend more, and build up your reserves. No wonder they take government support cash and buy safe, interest-earning government bonds with it. Effectively, the government is funding the gradual repair of bank balance sheets; it would be quicker and more honest if Uncle Sam and John Bull simply gave them enough cash to do the job.

But even that might not get the banks lending again. Would you, in their position?

Let's assume for a moment, sophisticated investor, that you have decided to stop day-trading because there's an increasing probability in this shark market that the bigger fool may turn out to be you. What longer-term investment might act as a safe haven for your gains?

• Western manufacturing industry, with its high costs of labor and regulation?
• Eastern manufacturing industry, so dependent on the once-profligate but now financially distressed Western consumer?
• Industrial commodities, which have soared in the busy economic boom but also because of leveraged speculation?
• Western real estate? Yes, the price-to-income ratio is dropping - but we haven't yet seen the drop in incomes that will continue the downward trend in nominal terms - especially as the borrower finds more of his limited income going on food and energy bills.
• Emerging markets real estate? One for the specialists, such as Marc Faber.
• Bank shares and sovereign debt? Junk bonds? Isn't that what got us into this mess?
• Agriculture? Maybe.
• Gold? Maybe - but what a rise it's seen in the last few years.
• Cash? Inflation isn't hitting everything - big-ticket items have gotten cheaper in real terms for decades. Here in the UK my first new compact car cost me £6,000 in 1989 and I could get another for that price now, with higher specifications. If you can pay your living expenses from income, maybe cash isn't such a crazy option.

For the way our governments (US/UK) are seeking to shore up the system doesn't look destined to work. The increased quantity of money, now used so cautiously and unproductively by the banks, is not going to offset the drop in velocity.

Later, if that money stays around and is not withdrawn quickly enough, then when we revive economic activity there will be a rush of general price inflation; but not, I think, for some years yet. Such inflation as we're seeing now has different causes and effects from the type we saw before, and has more to do with physical supply and demand rather than monetary expansion.

So some experts are predicting "troubles ahead", "unprecedented velocity collapse", a "double dip recession", or even a breakdown that will make us envy simpler, more sustainable societies.

I don't go with that last, but then again, I don't expect my house to burst into flame and yet I still have smoke detectors and fire insurance; so I do think it's good to build up easily-accessible emergency reserves against the possibility of temporary disruption.

There is no royal road to predicting economic developments. All the charts in the world are no use when the powers that be decide something different really has to be done. The system is not a machine but a poker game, and a crooked one at that. So I expect the course of events to be determined by a negotiation between the interests of the powerful, which in our democracies also (to some small extent) includes us, the ordinary people.

For now, I'm still holding cash and government inflation-linked bonds, but if the consequences of deflation are too painful for the populace, then the rules may well alter. Maybe, in time, we will indeed get hyperinflation, even though these days the currency is managed in a very different way from that of Germany in 1923. Dr Faber noted recently that gold and bonds rose together, a counterintuitive phenomenon he analysed as arising from fear of systemic collapse. This fear may also explain why India and China (among others) are boosting their holdings of physical gold, which is supporting the price even as other commodities deflate.

But that time of game-changing crisis is not, I think, with us yet.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Why "black swans" and "fat tails" happen more often than expected

The more system dynamics are repressed, the more likely it becomes that "improbable" events occur and "highly probable" trends dissolve or reverse.

Charles Hugh Smith

What are the chances of frozen peas being embedded in your kitchen ceiling? Vanishingly small - unless one of them gets stuck in the escape valve of your pressure cooker, as happened to a neighbour of ours, years ago.

Anatomy of a Hedge Fund

Last year, John Paulson, a hedge fund manager, made $5 billion dollars. There was a great deal of damage control on this news, including by Business Insider, explaining that $4 billion of that amount was gains from his own investment in his fund.

That lead me to the following analysis:

A typical hedge fund manager gets a 20%/2% to run the fund, which means 20% of the annual profit, and 2% of the value of the fund.

Assume no tax dodges, so that the investors (including the manager) pay 15% Capital Gains tax on the annual gains (directly from the fund).

Being confident in his own abilities, the manager invests his after-tax income in the fund.

At the start of a year, the investors have $M_old in the fund, the manager has $m_old, and the fund gains r%.

Capital Gains tax on the investor money is $0.15*r*M_old, 20% of the after-tax gain goes to the manager, and remainder gets rolled into the investor funds. The manager then gets 2% of the total.

For the manager, his share of the fund increases by $r*m_old, of which $0.15*r*m is Capital Gains tax. He also gains the 20% of the after-tax investor gains, and 2% of the fund, on which he pays a 35% tax rate.

Thus, we have

M_new = (0.98)*(1+(0.8)*(0.85)*r)*M_old

m_new = (1+(0.85)*r)*m_old+(0.2)*(0.85)*r*M_old+(0.65)*(0.02)*(1+(0.8)*(0.85)*r)*M_old

What is the result?

If the fund gains 20% per year, it only takes 16 years for more than half of the money in the fund to belong to the manager. At 10%, it takes 23 years.

Christine Lagarde's alter ego

Viewers of ITV's Dickinson's Real Deal will have been struck by the similarity between Chelsea antiques dealer and former drag queen Ian Towning, and the recently-appointed Head of the IMF, Christine Lagarde. Are they perhaps related?

Solar Flare Warning - world leaders go into hiding?

Ian Parker-Joseph relays news of a strong electromagnetic sunstorm that could potentially have catastrophic effects on our interconnected, electricity-dependent Western societies.

This would not be without precedent: in 1859, the strongest recorded solar storm, known as the "Carrington Event", caused telegraph systems to fail or be shut down. But the world then did not have electronics, and water and power supplies did not depend on electrically-operated and computer-controlled machinery.

The facts of the sun's storm and ejection of vast quantities of charged particles appear to be corroborated by the amateur heliological website solarham.com:

... and elsewhere, e.g. spaceweather.com, and pictures of the flare from 22 September here (example below):
Implications:

Should we avoid going outside? Not clear: according to this Wiki article, ultraviolet light replenishes the ozone layer by splitting O2, so it is when the sun is "quiet" that the layer thins and more UV light penetrates to the Earth's surface. But there may be more UV health risk if you live in high northern latitudes, where the ozone layer is already thin or holed.

Indirectly, health and safety could be compromised by the failure of electrical systems that govern and provide for so much in our urban lives. Should we lay up extra water and cold food? It wouldn't hurt.

I like IPJ's idea of cowardy-custard politicians cowering in underground shelters; let's hope nobody superglues the locks.

Humour: how the stockmarket works

CityUnslicker reproduces the following story; the earliest version online I can find is from 1st February 2001, but that references "Felix", which appears not to be the same-name student newspaper of Imperial College, London:

Once upon a time in a place overrun with monkeys, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest, and started catching them.

The man bought thousands at $10 and as supply started to diminish, they became harder to catch, so the villagers stopped their effort.

The man then announced that he would now pay $20 for each one. This renewed the efforts of the villagers and they started catching monkeys again. But soon the supply diminished even further and they were ever harder to catch, so people started going back to their farms and forgot about monkey catching.

The man increased his price to $25 each and the supply of monkeys became so sparse that it was an effort to even see a monkey, much less catch one.

The man now announced that he would buy monkeys for $50! However, since he had to go to the city on some business, his assistant would now buy on his behalf.

While the man was away the assistant told the villagers. 'Look at all these monkeys in the big cage that the man has bought. I will sell them to you at $35 each and when the man returns from the city, you can sell them to him for $50 each.'

The villagers rounded up all their savings and bought all the monkeys. They never saw the man nor his assistant again and once again there were monkeys everywhere.

Now you have a better understanding of how the stock market works.

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If you think this is an overly cynical view of the investment establishment, remember that it has been re-posted by a City insider.

Also, at an Oxford college reunion some years ago, long before the credit crunch, I was talking to a fellow graduate who was "something in the City" about my bearish views and my thought that the East might eventually take over the business of the Western exchanges. He boasted that the City was adept at swindling foreigners and would manage to do so for years to come.

I'm just putting that on record. Hubris?

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

The US' credit rating, the peril of interest rates and the need for wholesale reform

As you know, S&P downgraded the US' credit rating to AA+ last month. That's still a lot better than most countries in this financially shaky world. But as long ago as July 2010 Dagong, a credit rating agency working for America's biggest foreign creditor, China, rated the US "AA with a negative outlook".

Here are a few graphs to tell the story of US public debt, and the cost of paying the interest on it as a proportion of gross Federal tax collections:

This next one might be a little surprising, even heartening:

That is greatly influenced by the long-term decline in interest rates:

For the period up to and including fiscal year 2000, the average rate on public debt was slightly over 7%, and has been reducing since the recession of the early 1990s in order to stimulate (and then rescue) the economy.

Now let's look at what interest would have been payable in dollar terms, if the rate had been (say) 7% throughout:

Had that 7% rate been applied throughout, this is what it would have taken out of the gross tax collections:

That is the big worry, and why I don't doubt that there's a lot of collusion and fudging going on behind the scenes.

But that doesn't make me a Tea Partier. This is not a story about wicked old government and how we'd be better off without it altogether.

The reason why debt has become particularly dangerous over the last couple of years, is that Uncle Sam has been trying to save our bacon. Perhaps he's done it in the wrong way, and should have let gambler banks go down - you have so many more second tier banks to take over, unlike here in the UK. Maybe it's not too late to for the US to do that, in a controlled way, even now.

And yes, we all need to look at social benefits, though again I'm not with the let-the poor-starve party. For example, we might just possibly question the profits of pharmaceutical companies (with their endless me-too variants on perfectly good drugs that are coming out of copyright); the profits and contractual get-out weaselling of insurance companies; the battening of lawyers on the medical system; the training costs and remuneration of the medical profession. There is more than one way to trim the fat, apart from abandoning US citizens to bankruptcy, ill-health and premature death. Can we please get away from an Orwellian Animal-Farm-style slogan-bleating of "private good, public baaad"?

I do have an issue with both the US and UK governments, not about their power and control but the exact reverse: their failure to moderate the growth of private debt over the last 30 and more years. Counterintuitively (if you think the Right is responsible with money), it was under President Reagan and Prime Minister Margaret Thatcher that total debt to GDP soared, as I discuss at length in a previous post here, and most of that was private debt. Fighting one foe, they failed to notice the manoeuvering of another, namely the psychopathic greed of the financial industry whose aid they requested.

I am reminded how Ireland's freedom was lost because the King of Leinster invited the Normans to assist him in recovering his throne in Wexford, in 1169. Guinness-drinking Irish sentimentalists may lament "the Saxon foe across the water", but their real enemy was the bloodthirsty, land-hungry, Viking-descended Norman, and King Dermot MacMurrough, who let him in.

Both public and private sectors are due for reform.

INVESTMENT DISCLOSURE: None. Still in cash (and index-linked National Savings Certificates), and missing all those day-trading opportunities.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.