Portfolio Composition
Short USD/MXN 16.667 Percent
Long TRY/JPY 8.333 Percent
Cash 75 Percent
I booked profits on my big short USD/MXN position on the New York close yesterday, not so much on the anticipation of Plan B going down to defeat, but more rising rhetoric from both sides on Thursday. Furthermore, what appeared to be the low point looked like a harbinger to a Friday afternoon selloff, especially in riskier assets like emerging market currencies. Indeed, USD/MXN has surged up to 12.95, a one day topside move of nearly 1800 pips.
Last night's Asian session was a bit less dramatic. USD/MXN popped but then consolidated around 12.85, and I was probably a bit trigger happy when I got back in at that level. However, it was a small position and I still have lots of firepower to take advantage of any overdone moves to the topside. Many technical analysts think USD is already overbought, however, there remains substantial risk for further short term dollar strength on any sort of overzealous comments from Washington players or further entrenchment from either side. I am looking add slightly to my USD/MXN short position at 13. JPY was also quite volatile, and I was able to book a modest profit on an intra-session USD/JPY deal.
With the House gone until the 27th, all eyes are on any action the White House or the Senate might take to calm markets. I plan to sell USD/MXN in small steps as the greenback gains strength on cliff fears. I maintain my 12.5-6 mid 2013 target, for now.
Friday, December 21, 2012
Monday, December 17, 2012
Midweek Position Summary: Playing the Fiscal Cliff, Yen Weakness, and a non Mexico Growth Story
Portfolio Composition:
Short USD/MXN 50 percent
Long TRY/JPY 8.3 percent
Cash 41.7 percent
Booked a handsome post-election profit on a long USD/JPY position over the weekend, freeing up cash which accounts for my considerable reserve of unemployed funds. I remain cautiously optimistic that the Mexican Peso will finish the year strong, and therefore maintain sizable short USD/MXN position. At the same time, I plan to keep at least 25 percent of my portfolio in cash to insulate myself against fiscal cliff driven volatility, or to take advantage of pullbacks caused by delays in the negotiations between the White House and Congress.
Playing the Yen weakness longterm, I have established a very small long TRY/JPY position. Turkey's economy has considerable exposure to Europe, which is the destination for much of its exports. While I expect Europe will slowly but surely walk away from the cliff and return to growth, the path will be long and volatile. At the same time, Turkey has also diversified its exports, selling its products to booming central Asian and Mideastern economies. Turkey is slowly consolidating its fiscal position. The Turkish government has shrunk the deficit to 1.4 percent of GDP from the 2010 peak of 5.5 percent of GDP, albeit probably at the expense of considerable growth. However, the normalizing of the economy has caused inflation, a major concern two years ago, to ease considerably. Turkey's massive current account deficit, reaching nearly 10 percent of GDP, is a priority for both the government and central bank. Turkey must import 97 percent of its energy. However, Turkey is currently bringing a pipeline from the Caspian Sea online. Turkey remains vulnerable to regional instability, with borders with Iraq, Iran and Syria. Indeed, a Syrian rocket attack on a Turkish border town caused a sell off of Turkish assets last month. The Lira regained its footing and then some however within days. Despite these downside risks, Turkey remains a strong growth story that was brought to an untimely end by the 2008 crisis. Turkey's own banks weathered the crisis fine, and it was only global external factors which drove Turkey into recession. As the world recovery takes hold, I expect demand for Turkish assets and products to strengthen. Finally the efforts by the central bank to shore up the current account deficit should also lend support to the Lira.
In sum, opportunities exist for investors willing to do the work. But as always, great care is required.
Short USD/MXN 50 percent
Long TRY/JPY 8.3 percent
Cash 41.7 percent
Booked a handsome post-election profit on a long USD/JPY position over the weekend, freeing up cash which accounts for my considerable reserve of unemployed funds. I remain cautiously optimistic that the Mexican Peso will finish the year strong, and therefore maintain sizable short USD/MXN position. At the same time, I plan to keep at least 25 percent of my portfolio in cash to insulate myself against fiscal cliff driven volatility, or to take advantage of pullbacks caused by delays in the negotiations between the White House and Congress.
Playing the Yen weakness longterm, I have established a very small long TRY/JPY position. Turkey's economy has considerable exposure to Europe, which is the destination for much of its exports. While I expect Europe will slowly but surely walk away from the cliff and return to growth, the path will be long and volatile. At the same time, Turkey has also diversified its exports, selling its products to booming central Asian and Mideastern economies. Turkey is slowly consolidating its fiscal position. The Turkish government has shrunk the deficit to 1.4 percent of GDP from the 2010 peak of 5.5 percent of GDP, albeit probably at the expense of considerable growth. However, the normalizing of the economy has caused inflation, a major concern two years ago, to ease considerably. Turkey's massive current account deficit, reaching nearly 10 percent of GDP, is a priority for both the government and central bank. Turkey must import 97 percent of its energy. However, Turkey is currently bringing a pipeline from the Caspian Sea online. Turkey remains vulnerable to regional instability, with borders with Iraq, Iran and Syria. Indeed, a Syrian rocket attack on a Turkish border town caused a sell off of Turkish assets last month. The Lira regained its footing and then some however within days. Despite these downside risks, Turkey remains a strong growth story that was brought to an untimely end by the 2008 crisis. Turkey's own banks weathered the crisis fine, and it was only global external factors which drove Turkey into recession. As the world recovery takes hold, I expect demand for Turkish assets and products to strengthen. Finally the efforts by the central bank to shore up the current account deficit should also lend support to the Lira.
In sum, opportunities exist for investors willing to do the work. But as always, great care is required.
Friday, December 14, 2012
Weekend Update: Where We Go from Here
Since this blog is ultimately about trading FX and making money, it is time to take a time out from the long nuanced commentaries of the past few posts and talk about trades again. Specifically, what positions should one take, when should they be established, and when should profits be taken.
News on the fiscal cliff was muted today due to the tragic shooting in Connecticut. As a result, markets were able to consolidate and extend gains from Wednesday's Fed announcement. The Euro reached an intra day peak against USD of 1.3173, the highest since May, before closing at 1.3155 in New York. The Aussie dollar held gains as well, closing at a respectable 1.0556 versus USD. Mexico's peso swung wildly throughout the day, plunging nearly 1000 pips against USD before regaining its footing in the 12.73-12.76 range. The day's biggest mover was JPY, which experienced a bear market rally, closing up against all major peers. The Japanese yen has been under tremendous pressure as the likely winner of Japan's December 16th elections has called for fiscal and monetary stimulus to boost a Japanese economy which has fallen back into recession. Former Prime Minister Shinzo Abe of the conservative Liberal Democratic Party is poised to return to power after unexpectedly resigning in 2007 less than a year into his term amid string of foreign policy failures. Mr. Abe has now built a campaign around reviving Japan's stagnant economy. The candidate has openly criticized the Bank of Japan, and has called for "unlimited stimulus" and an inflation target of at least two percent. LDP has dominated post-war Japanese politics, ruling continuously from 1955 to 1993, and 1994 to 2009.
With polls predicting an overwhelming win for LDP over the center-left Democratic party headed by PM Noda, speculators have been establishing a huge short yen position since mid November. According the Commodities Futures Trading Commission, the market has massed a 14.3 billion dollar net short position on JPY, the largest since July 2007. While it is not certain if this development represents a true pricing in of Japan's weak fundamentals, or a speculative move by traders to profit from the elections, the evidence points to the latter. Japan's massive debt levels, loss of comparative advantage, chronic deflation problems, and aging population couple with a closed door immigration policy have been festering for decades. Only extreme external risk aversion, which has pushed some investors into the yen due to its historic role as a safe haven, has allowed the currency to achieve post war highs in the face of deteriorating internal fundamentals. In sum, the Yen, despite the considerable structural problems facing the Japanese economy, is most likely oversold in the short term, with speculators looking to make quick profits over the weekend.
As such, I expect to see USD/JPY reach 84.10-20 levels Sunday night stateside, and then sell off as the yen bears ring the cash register. Where the yen ends up after the profit taking is over will be good indicator as to the degree to which the 'conviction trade' has pushed the yen lower. Specifically, it will be very interesting to see if the yen holds its gains from the rollout of the Fed's new easing program on Wednesday.
Considering these facts, shorting the yen now with plans to take profits on Sunday, or buying AUD, CAD, or USD against the yen after the post election dip are both very attractive options. Europe also appears to be finally uniting. The best play to profit from this is to sell USD/NOK or USD/SEK on rallies. The Scandinavian economies have some of the strongest fundamentals on the Continent, well capitalized banks, and a sturdy and well regulated financial system. The Scandies also offer modest yield; NOK and SEK yield 150 and 125 bps respectively. Currently, I am short USD/SEK with a longterm target of 6.3 to the dollar. Finally, USD/MXN remains a sell on rallies, though one must be cautious as MXN is especially sensitive to news (good or bad) about the fiscal cliff. Any dip in the peso back into the 13 to 13.20 range would be a very attractive opportunity to establish or add to any long peso position.
News on the fiscal cliff was muted today due to the tragic shooting in Connecticut. As a result, markets were able to consolidate and extend gains from Wednesday's Fed announcement. The Euro reached an intra day peak against USD of 1.3173, the highest since May, before closing at 1.3155 in New York. The Aussie dollar held gains as well, closing at a respectable 1.0556 versus USD. Mexico's peso swung wildly throughout the day, plunging nearly 1000 pips against USD before regaining its footing in the 12.73-12.76 range. The day's biggest mover was JPY, which experienced a bear market rally, closing up against all major peers. The Japanese yen has been under tremendous pressure as the likely winner of Japan's December 16th elections has called for fiscal and monetary stimulus to boost a Japanese economy which has fallen back into recession. Former Prime Minister Shinzo Abe of the conservative Liberal Democratic Party is poised to return to power after unexpectedly resigning in 2007 less than a year into his term amid string of foreign policy failures. Mr. Abe has now built a campaign around reviving Japan's stagnant economy. The candidate has openly criticized the Bank of Japan, and has called for "unlimited stimulus" and an inflation target of at least two percent. LDP has dominated post-war Japanese politics, ruling continuously from 1955 to 1993, and 1994 to 2009.
With polls predicting an overwhelming win for LDP over the center-left Democratic party headed by PM Noda, speculators have been establishing a huge short yen position since mid November. According the Commodities Futures Trading Commission, the market has massed a 14.3 billion dollar net short position on JPY, the largest since July 2007. While it is not certain if this development represents a true pricing in of Japan's weak fundamentals, or a speculative move by traders to profit from the elections, the evidence points to the latter. Japan's massive debt levels, loss of comparative advantage, chronic deflation problems, and aging population couple with a closed door immigration policy have been festering for decades. Only extreme external risk aversion, which has pushed some investors into the yen due to its historic role as a safe haven, has allowed the currency to achieve post war highs in the face of deteriorating internal fundamentals. In sum, the Yen, despite the considerable structural problems facing the Japanese economy, is most likely oversold in the short term, with speculators looking to make quick profits over the weekend.
As such, I expect to see USD/JPY reach 84.10-20 levels Sunday night stateside, and then sell off as the yen bears ring the cash register. Where the yen ends up after the profit taking is over will be good indicator as to the degree to which the 'conviction trade' has pushed the yen lower. Specifically, it will be very interesting to see if the yen holds its gains from the rollout of the Fed's new easing program on Wednesday.
Considering these facts, shorting the yen now with plans to take profits on Sunday, or buying AUD, CAD, or USD against the yen after the post election dip are both very attractive options. Europe also appears to be finally uniting. The best play to profit from this is to sell USD/NOK or USD/SEK on rallies. The Scandinavian economies have some of the strongest fundamentals on the Continent, well capitalized banks, and a sturdy and well regulated financial system. The Scandies also offer modest yield; NOK and SEK yield 150 and 125 bps respectively. Currently, I am short USD/SEK with a longterm target of 6.3 to the dollar. Finally, USD/MXN remains a sell on rallies, though one must be cautious as MXN is especially sensitive to news (good or bad) about the fiscal cliff. Any dip in the peso back into the 13 to 13.20 range would be a very attractive opportunity to establish or add to any long peso position.
Thursday, December 13, 2012
Commentary: A Clearer Picture Emerges on US Monetary Policy
The Federal Reserve System made news yesterday with two announcements. The system will more aggressively expand its balance sheet in the coming months, purchasing an additional 45 billion in US Treasury securities on top of the 40 billion in monthly MBS purchases announced in September. The Fed has also announced specific thresholds for when it might stop easing-- until unemployment is below 6.5 percent and/or inflation is above 2.5 percent. From this news, a clearer picture has emerged as to outlook for US monetary policy. First, the System's balance sheet will almost certainly reach 4 trillion dollars. This confirms the expectations of many analysts, and will mean that the unwinding of the Fed's balance sheet will take even longer than originally expected. Secondly, on Wednesday Bernanke tacitly acknowledged during his post meeting press conference the fact that rate increases won't be possible until the Fed sells enough securities to soak up the mass of excess banking reserves.
" It is worth noting that the goals of the FOMC’s asset purchases and of its federal funds rate guidance are somewhat different. The goal of the asset purchase program is to increase the near-term momentum of the economy by fostering more accommodative financial conditions, while the purpose of the rate guidance is to provide information about the future circumstances under which the Committee would contemplate reducing accommodation. I would emphasize that a decision by the Committee to end asset purchases, whenever that point is reached, would not be a turn to tighter policy. While in that circumstance the Committee would no longer be increasing policy accommodation, its policy stance would remain highly supportive of growth. Only at some later point would the Committee begin actually removing accommodation through rate increases. Moreover, as I have discussed today, the decisions to modify the asset purchase program and to undertake rate increases are tied to different criteria."
Bernanke cannot directly state that the Fed could not raise the Federal Funds Rate today, for fear of undermining the central bank's credibility. However, we are beginning to see the contours of what the exit strategy will look like. The Fed will cease asset purchases, the Fed will maintain its zero interest rate policy for a time, the Fed will slowly sell securities to soak up the mass of excess reserves, and finally, the Fed will undertake rate increases. This process will take at least five years. In short, along the roadmap to monetary tightening, one can see many of the signposts recently pointed out by your humble analyst.
" It is worth noting that the goals of the FOMC’s asset purchases and of its federal funds rate guidance are somewhat different. The goal of the asset purchase program is to increase the near-term momentum of the economy by fostering more accommodative financial conditions, while the purpose of the rate guidance is to provide information about the future circumstances under which the Committee would contemplate reducing accommodation. I would emphasize that a decision by the Committee to end asset purchases, whenever that point is reached, would not be a turn to tighter policy. While in that circumstance the Committee would no longer be increasing policy accommodation, its policy stance would remain highly supportive of growth. Only at some later point would the Committee begin actually removing accommodation through rate increases. Moreover, as I have discussed today, the decisions to modify the asset purchase program and to undertake rate increases are tied to different criteria."
Bernanke cannot directly state that the Fed could not raise the Federal Funds Rate today, for fear of undermining the central bank's credibility. However, we are beginning to see the contours of what the exit strategy will look like. The Fed will cease asset purchases, the Fed will maintain its zero interest rate policy for a time, the Fed will slowly sell securities to soak up the mass of excess reserves, and finally, the Fed will undertake rate increases. This process will take at least five years. In short, along the roadmap to monetary tightening, one can see many of the signposts recently pointed out by your humble analyst.
Sunday, December 9, 2012
News: Fed Expected to Expand Bond Purchases This Week as Incoming Pena Nieto Administration Submits Balanced Budget
Markets this week are expecting the US Federal Reserve System to announce an expansion of its new bond purchase program. Currently, the Federal Reserve is purchasing 40 billion in mortgage debt in an effort to boost the housing market. The financial press is currently speculating about the how the Fed will implement the expansion of its so-called QE3 bond purchase program. The Fed could augment its purchase of securitized mortgage debt up to 80 billion. The Fed may also purchase a further 40 billion a month of treasury securities. This possibility would ease the Fed's task of implementing an exit strategy when it needs to withdraw the unprecedented stimulus it has provided to a sagging economy, since selling treasuries is easier to implement than selling securitized mortgages.
Meanwhile, talks over the looming fiscal cliff continue to grab headlines as the White House and Congress struggle to hammer out a deal. South of the border, the incoming Pena Nieto administration in Mexico has submitted a balanced budget for 2013. Mexican law requires a balanced budget, a restriction that can be removed by an act of Congress. The conservative PAN coalition had received approval to run deficits in 2009 as Mexico sought to support its economy in the wake of the financial crisis. Mexico has been slowly shrinking its deficit since then, running a deficit of only 0,5 percent of GDP in 2012. The new government will close the lingering shortfall by seeking out efficiency savings in the federal government and allowing income tax cuts for top earners to expire. Under the plan, Mexico's top tax bracket will rise from 29 percent to 30 percent after the first of year. Mexico also hopes to reduce it borrowing cost if rating agencies decide to reward Mexico's actions with a sovereign upgrade. Mexico's Peso opened higher in Asia this evening at 12.835, up from Friday's 12.875 New York close.
Saturday, December 8, 2012
Commentary: It Could be 2020 until the next US Rate Hike
The Federal Reserve System has taken unprecedented action since the financial crisis and the ensuing recession to ease credit conditions across the entire money market, from interbank lending to home loans. For the record, I believe that these steps were absolutely necessary to both preserve a functioning financial system and accelerate the recovery from the resultant business contraction. Putting the merits of these actions aside however, I wish to examine how the Federal Reserve will implement a normalization of policy.
The Fed's pre-crisis balance sheet totaled 820 billion, while the banking system in aggregate had a mere 1.5 billion in excess reserves. As of this month, the Fed's balance sheet has grown to 2.8 trillion, and will continue to grow larger as the Fed's new mortgage bond purchase program is implemented. Excess reserves now stand at 1.6 trillion. While the tripling of the Fed's balance was has drawn both praise and ire, the 1000 fold increase in banking reserves has been largely ignored by the financial press. It is crucial to note that the Fed sets the Fed funds rate by augmenting or decreasing the aggregate reserve of the banking system by buying or selling securities on the open market. The 1.5 billion in excess reserves could be easily augmented pre-crisis with the sale of a tiny fraction of the Fed's total balance sheet. It is conceivable that in such a scenario a the Fed funds rate could be raised by selling under 100 million in securities. Today however, with banking reserves at 1.6 trillion, the Fed may very well have to dump hundreds of billions or even a trillion worth of securities onto the market in order to raise its target rate. Executing these trades would take years, not weeks or days. In short, the System could not raise the Fed funds rate today even if it wanted to.
The communication of the Fed to maintain a 'highly accomodative' policy until mid 2015 has been interpreted by most actors as forward guidance for the timing of the first rate hike. However, in order to raise rates in 2015, the Fed would need to have already begun quietly unwinding its balance sheet so that it could execute the trades in 2015 that would actually affect a change in the Fed funds rate. On the contrary, the Fed is still expanding its balance sheet. It will certainly surpass 3 trillion, and may even reach 4 trillion if current asset purchase programs are continued or expanded.
In sum, the Fed probably won't be able to raise the rates in 2015 either. The mid 2015 date is most likely the point when the System will begin to sell off its treasury and mortgage holdings. However, the sheer size of the excess reserves, and the reluctance of the Fed to shock the markets by dumping trillions of debt in one shot, will mean it will be years before the unwinding causes rates to rise. In sum, it is not at all unlikely that the Fed will not be able to swiftly and effectively target the Fed funds rate until 2019.
As the Fed has intervened in unprecedented ways to provide stimulus to the economy, it will also take non traditional methods to withdraw this stimulus at the appropriate time. Powerless to rapidly change the Fed funds rate, the Fed will be forced to attempt to quarantine excess banking reserves by raising the rate of interest it pays on deposits at the System's twelve banks. This may tightened credit conditions, but it is uncharted territory. It must also be mentioned that this policy essentially entails paying the banks to withdraw credit from the public. This could become a political problem for the Fed, considering that Congress only just granted the Fed the power to pay interest on deposits in 2008.
No matter which way you look at it, the Fed's exit strategy will be a long and highly complex process that will take years to execute. With the mind boggling growth of the monetary base, and the impracticability of selling trillions of dollars worth of securities all at once, 2020 is a reasonable estimate for the first increase in the Fed funds rate.
Monday, December 3, 2012
Mid Week Position Summary
Short USD/MXN
Got lucky for once in a long time and booked a modest profit at the psychological level of 12.9, only to see USD/MXN surge back up to 13 in late afternoon trading, presumably over fiscal cliff concerns. The Peso had surged Sunday night in Asian markets, only to give back everything and then some once traders stateside got a chance to put in their two cents. If anything, the heated rhetoric between President Obama and Speaker Boehner might not have as much an impact in non-English speaking markets. I plan to re-establish my short position, selling in quarters at 13.05, 13.15, 13.2 and 13.29. My target will be 12.95. Meanwhile, I will keep a segregated small short position for the interest income and the Q4 target of 12 flat.
Got lucky for once in a long time and booked a modest profit at the psychological level of 12.9, only to see USD/MXN surge back up to 13 in late afternoon trading, presumably over fiscal cliff concerns. The Peso had surged Sunday night in Asian markets, only to give back everything and then some once traders stateside got a chance to put in their two cents. If anything, the heated rhetoric between President Obama and Speaker Boehner might not have as much an impact in non-English speaking markets. I plan to re-establish my short position, selling in quarters at 13.05, 13.15, 13.2 and 13.29. My target will be 12.95. Meanwhile, I will keep a segregated small short position for the interest income and the Q4 target of 12 flat.
Sunday, December 2, 2012
Commentary: Keynes, Moneterism, and the Fiscal Cliff.
I am indebted to Dr. E.K. Hunt for his wonderfully insightful and elucidative book, History of Economic Thought. Some ideas here are his; reading his book also helped me to organize and understand my own thoughts in meaningful and important ways. Dr. Hunt, your work has changed my life, and for that I am grateful.
The budgetary adjustment facing the United States on January 1st, 2013 is no long coming fiscal reckoning. The capital markets continue to eagerly lend to the United States government, as evidenced by record low yields on federal securities. There is no debt crisis; the US treasury continues to make interest payments on outstanding debt, and finances budgetary shortfalls via the sale of bonds and bills. If anything, the US has the opposite of a debt crisis. The federal government has lower borrowing costs and better access to financing than at any time in history. So the fiscal cliff is not the result of decades of Washington recklessness. Rather, it is an artificial deadline, imposed by a dysfunctional and insane Congress on an embattled President. Now that President has managed to get re-elected, despite the best efforts of the insurrectionists in the US House of Representatives who threatened to bring down the federal government and destroy its credit worthiness simply to win an election. If anything, President Obama's win last month was a victory for builders over destroyers, and a stinging defeat for those who would burn down the house rather accept the will of the majority of its occupants. But I digress. I wish to examine the fiscal situation facing our country from a historical perspective that begins long before the rise of the tea party, the ascension of Barack Obama, or the passage of the Bush tax cuts. For this, we must look back at a century and a half of economic thought and industrial history. For the current US fiscal outlook did not begin with cutting taxes for the rich, or two unfunded wars, though these events are certainly symptoms of the status quo. Rather, the situation we find ourselves in is the direct result of the slow but steady evolution of social, industrial, economic, and monetary structures, the understanding and elucidation of which is the only way possible to understand (and ultimately escape) our current predicament. In this paper, I intend to do just that.
The Great Depression of the 1930s was undoubtedly the biggest economic crisis of the past 100 years. As late as 1939, unemployment was as high as 20 percent. Apart from being an economic crisis with untold human suffering, the Great Depression represented a crisis for economic thought which until the 1930s had been dominated by the neoclassical school. Importantly, the neoclassical economists' theory of employment, wages, and income distribution held that involuntary unemployment was impossible, and that unemployment was the result of workers refusing to accept a lower wage. This conclusion rested solely upon the idea of the value of marginal product theory of income distribution which held that: 1. Each successive unit of output resulted in lower returns in terms of value for society. 2. Each successive worker to enter the labor force then resulted in a lower marginal return on the output of their labor. 3. Competition between workers caused the wage rate to fall to the value of the last successive unit of output. In other words, the wage rate equaled the marginal value of the product of labor. These three postulates also necessitate the conclusion that as competition drives down wages to the value of the marginal product of labor, profits must rise for the entrepreneurs by an equal amount. Or in macro-economic terms, as the wage rate falls, the interest rate on capital rises by an equal magnitude. We must therefore conclude as output and gross employment rises, the distribution of income necessarily becomes more unequal.
The conditions on the ground during the 1930s however struck at the very foundations of this elegant theoretical edifice which had been meticulously developed over the past half century. First, as industrial output plummeted wages for workers who remained employed fell sharply, while neoclassical theory predicted they would rise as the less output meant that the marginal value of the output of each worker lucky enough to keep his job would rise as well. Secondly, many unemployed workers were willing to work well below prevailing wage rates, yet no opportunities existed. Large masses could then be said to be legitimately 'involuntarily unemployed,' which directly contradicted neoclassical dogma.
For John Maynard Keynes, a British economist brought up on the neoclassical school, the Great Depression was a fascinating challenge. On the one hand, Keynes essentially agreed with the neoclassicists that both households and firms were rational maximizers whose interests were in harmony when the market was in equilibrium. Keynes' major contribution to economic theory were the following insights. 1. Interest on financial capital was the reward for parting with liquidity, not a reward for delaying consumption as held by neoclassical theory. 2. A large component in the demand for money was the so-called speculative motive. For example, when the market expected interest rates to rise, investors would be reluctant to hold bonds with long maturities for fear of a sharp rise in interest rates. It was always good to hold a significant amount of liquid cash to take advantage of a potential rise in the rate of interest. 3. While the rate of interest was the equilibrium point which balanced savings with investment, it was possible for there to be so much excess savings in the market that to bringing into equilibrium with investment would require a negative rate of interest. It was these cases which Keynes sought to understand better. Keynes essentially believed that when savings and investments could be brought into equilibrium by a rate of interest above zero, the simple prescription was for the central bank to create enough money to lower the rate of interest sufficiently to its equilibrium level. When this was impossible because the market demanded a negative rate of interest to make savings equal investment, another solution entirely was required.
Before proceeding, it is crucial to reiterate that Keynes, like his neoclassicist predecessors, believed that total income in the economy must equal total spending. For example, expenditures by households on consumption goods were income for firms. Likewise, the investments one firm made on machines to make goods was income for the firm which constructed the machines. Thus, total output must also equal total spending, since firms would not produce goods they could not sell. Keynes expressed this concept with the equation A = I + C + G, where A is 'autonomous spending,' I is investment, C is consumption, and G is government spending. We will revisit this equation shortly as we discuss the principal policy recommendation for Keynes' analysis, deficit spending by government.
Keynes' theory of interest essentially stated that excess savings as compared to investment drove down the rate of interest. However, the equilibrium rate of interest at which investments and savings were equal could be below zero. In practice, savers would never lend out their money at negative rates. In such cases, Keynes advocated that governments become the borrower of last resort by issuing bonds to finance large deficits. The government therefore was essentially providing an investment outlet for all of the excess savings in the economy. The government would then spend these borrowed funds to increase spending in the economy and therefore total output. Keynes advocated the initiation of 'useful projects' such as the construction of schools and roads. It should be noted however that Keynes saw the government's ultimate role was to soak up and spend the excess savings for which private investors could not find profitable outlets. For this reason, Keynes believed that spending money to employ men to dig ditches and then refill them would be nearly as effective as building bridges.
The problem of excess savings has its origin in two places. First is the lack of profitable investment outlets. This can be solved by the issuance of government bonds which pay a fixed rate of interest, as these securities are essentially seen as risk free. And as discussed above, investment can be stimulated by a lowering of the interest rate by the monetary authorities. But only when the equilibrium rate for savings and investment is above zero. A second and perhaps more important cause of excess savings is the gross and ever increasing income inequality which the neoclassical theory predicts is the inevitable outcome of capitalism. As a small but powerful class of absentee owners gains a larger and larger share of the national income which it cannot possibly consume or invest profitably, total spending drops (and savings rises) and therefore output falls. Is it any wonder, therefore, that as wealth has become more and more concentrated, government debt has soared and deficits have exploded? As more and more excess savings is socked away in the hands of the few, the government has been forced to provide the investment outlets (ie, issue more bonds) so that spending and therefore output does not fall.
The Keynesian prescription has necessitated the creation of incredibly intricate and fragile networks of creditors and debtors. Banks and financial firms become creditors of governments, while simultaneously being indebted to their depositors, investors, and shareholders. Inevitably, some of the excess savings has found its way into the hands of households in the form of bankcards and other forms of consumer credit. This enhances demand for the products and services of the entrepreneurs, who in turn issue bonds to finance capital investments to keep pace with growing consumer spending. The result is that nearly all actors become both large creditors and debtors. This elaborate network of debt knows no national boundaries, and any possible default at the government, firm, or household level could bring down the entire system.
Such a possibility explains the extraordinary action taken by central banks after the collapse of Lehman Brothers in 2008. The failure of such a large debtor to make good on its obligations threatened the capacity of many of the firm's creditors, themselves debtors, to meet their respective obligations. The potential ripple effects threatened to bring down the entire economy. We need not examine in detail the government response to the 2008 crisis. Suffice to say, this time, the worst seems to have been averted. However, the growing disparity of income become rich and poor, which has become worse still since 2008, will continue to put ever increasing stress on the financial system and central banks as economies are forced to create ever more elaborate and complex credit relationships to re-inject into the economy the huge sums of excess cash held by a super elite class of mega capitalists.
In sum, while it is indisputable that the massive government spending during the second world war and the post war reconstruction ended the great depression and brought on a two decades of relative global prosperity, I fear that long term sustainable growth will never be attainable without a more equitable distribution of income. Our present course which does not nothing to address income inequality will lead to a cascade of financial crises, growing in scope and complexity, as banks and financial firms are forced to create riskier and more interdependent credit relationships between households, firms, and a plutocratic elite. Meanwhile, central banks will come under ever increasing pressure as they are forced to constantly ease credit conditions to spur sidelined savings into profitable investment outlets. Central governments will become even more indebted as they try in vain to soak up all the excess savings by the endless issuance of bonds to both fund new projects and refinance old debt. The seas appear to be calming, and a debt deal in Washington seems likely. However, steering around the fiscal speed bump in January does nothing to change our trajectory towards the ultimate day of reckoning.
The budgetary adjustment facing the United States on January 1st, 2013 is no long coming fiscal reckoning. The capital markets continue to eagerly lend to the United States government, as evidenced by record low yields on federal securities. There is no debt crisis; the US treasury continues to make interest payments on outstanding debt, and finances budgetary shortfalls via the sale of bonds and bills. If anything, the US has the opposite of a debt crisis. The federal government has lower borrowing costs and better access to financing than at any time in history. So the fiscal cliff is not the result of decades of Washington recklessness. Rather, it is an artificial deadline, imposed by a dysfunctional and insane Congress on an embattled President. Now that President has managed to get re-elected, despite the best efforts of the insurrectionists in the US House of Representatives who threatened to bring down the federal government and destroy its credit worthiness simply to win an election. If anything, President Obama's win last month was a victory for builders over destroyers, and a stinging defeat for those who would burn down the house rather accept the will of the majority of its occupants. But I digress. I wish to examine the fiscal situation facing our country from a historical perspective that begins long before the rise of the tea party, the ascension of Barack Obama, or the passage of the Bush tax cuts. For this, we must look back at a century and a half of economic thought and industrial history. For the current US fiscal outlook did not begin with cutting taxes for the rich, or two unfunded wars, though these events are certainly symptoms of the status quo. Rather, the situation we find ourselves in is the direct result of the slow but steady evolution of social, industrial, economic, and monetary structures, the understanding and elucidation of which is the only way possible to understand (and ultimately escape) our current predicament. In this paper, I intend to do just that.
The Great Depression of the 1930s was undoubtedly the biggest economic crisis of the past 100 years. As late as 1939, unemployment was as high as 20 percent. Apart from being an economic crisis with untold human suffering, the Great Depression represented a crisis for economic thought which until the 1930s had been dominated by the neoclassical school. Importantly, the neoclassical economists' theory of employment, wages, and income distribution held that involuntary unemployment was impossible, and that unemployment was the result of workers refusing to accept a lower wage. This conclusion rested solely upon the idea of the value of marginal product theory of income distribution which held that: 1. Each successive unit of output resulted in lower returns in terms of value for society. 2. Each successive worker to enter the labor force then resulted in a lower marginal return on the output of their labor. 3. Competition between workers caused the wage rate to fall to the value of the last successive unit of output. In other words, the wage rate equaled the marginal value of the product of labor. These three postulates also necessitate the conclusion that as competition drives down wages to the value of the marginal product of labor, profits must rise for the entrepreneurs by an equal amount. Or in macro-economic terms, as the wage rate falls, the interest rate on capital rises by an equal magnitude. We must therefore conclude as output and gross employment rises, the distribution of income necessarily becomes more unequal.
The conditions on the ground during the 1930s however struck at the very foundations of this elegant theoretical edifice which had been meticulously developed over the past half century. First, as industrial output plummeted wages for workers who remained employed fell sharply, while neoclassical theory predicted they would rise as the less output meant that the marginal value of the output of each worker lucky enough to keep his job would rise as well. Secondly, many unemployed workers were willing to work well below prevailing wage rates, yet no opportunities existed. Large masses could then be said to be legitimately 'involuntarily unemployed,' which directly contradicted neoclassical dogma.
For John Maynard Keynes, a British economist brought up on the neoclassical school, the Great Depression was a fascinating challenge. On the one hand, Keynes essentially agreed with the neoclassicists that both households and firms were rational maximizers whose interests were in harmony when the market was in equilibrium. Keynes' major contribution to economic theory were the following insights. 1. Interest on financial capital was the reward for parting with liquidity, not a reward for delaying consumption as held by neoclassical theory. 2. A large component in the demand for money was the so-called speculative motive. For example, when the market expected interest rates to rise, investors would be reluctant to hold bonds with long maturities for fear of a sharp rise in interest rates. It was always good to hold a significant amount of liquid cash to take advantage of a potential rise in the rate of interest. 3. While the rate of interest was the equilibrium point which balanced savings with investment, it was possible for there to be so much excess savings in the market that to bringing into equilibrium with investment would require a negative rate of interest. It was these cases which Keynes sought to understand better. Keynes essentially believed that when savings and investments could be brought into equilibrium by a rate of interest above zero, the simple prescription was for the central bank to create enough money to lower the rate of interest sufficiently to its equilibrium level. When this was impossible because the market demanded a negative rate of interest to make savings equal investment, another solution entirely was required.
Before proceeding, it is crucial to reiterate that Keynes, like his neoclassicist predecessors, believed that total income in the economy must equal total spending. For example, expenditures by households on consumption goods were income for firms. Likewise, the investments one firm made on machines to make goods was income for the firm which constructed the machines. Thus, total output must also equal total spending, since firms would not produce goods they could not sell. Keynes expressed this concept with the equation A = I + C + G, where A is 'autonomous spending,' I is investment, C is consumption, and G is government spending. We will revisit this equation shortly as we discuss the principal policy recommendation for Keynes' analysis, deficit spending by government.
Keynes' theory of interest essentially stated that excess savings as compared to investment drove down the rate of interest. However, the equilibrium rate of interest at which investments and savings were equal could be below zero. In practice, savers would never lend out their money at negative rates. In such cases, Keynes advocated that governments become the borrower of last resort by issuing bonds to finance large deficits. The government therefore was essentially providing an investment outlet for all of the excess savings in the economy. The government would then spend these borrowed funds to increase spending in the economy and therefore total output. Keynes advocated the initiation of 'useful projects' such as the construction of schools and roads. It should be noted however that Keynes saw the government's ultimate role was to soak up and spend the excess savings for which private investors could not find profitable outlets. For this reason, Keynes believed that spending money to employ men to dig ditches and then refill them would be nearly as effective as building bridges.
The problem of excess savings has its origin in two places. First is the lack of profitable investment outlets. This can be solved by the issuance of government bonds which pay a fixed rate of interest, as these securities are essentially seen as risk free. And as discussed above, investment can be stimulated by a lowering of the interest rate by the monetary authorities. But only when the equilibrium rate for savings and investment is above zero. A second and perhaps more important cause of excess savings is the gross and ever increasing income inequality which the neoclassical theory predicts is the inevitable outcome of capitalism. As a small but powerful class of absentee owners gains a larger and larger share of the national income which it cannot possibly consume or invest profitably, total spending drops (and savings rises) and therefore output falls. Is it any wonder, therefore, that as wealth has become more and more concentrated, government debt has soared and deficits have exploded? As more and more excess savings is socked away in the hands of the few, the government has been forced to provide the investment outlets (ie, issue more bonds) so that spending and therefore output does not fall.
The Keynesian prescription has necessitated the creation of incredibly intricate and fragile networks of creditors and debtors. Banks and financial firms become creditors of governments, while simultaneously being indebted to their depositors, investors, and shareholders. Inevitably, some of the excess savings has found its way into the hands of households in the form of bankcards and other forms of consumer credit. This enhances demand for the products and services of the entrepreneurs, who in turn issue bonds to finance capital investments to keep pace with growing consumer spending. The result is that nearly all actors become both large creditors and debtors. This elaborate network of debt knows no national boundaries, and any possible default at the government, firm, or household level could bring down the entire system.
Such a possibility explains the extraordinary action taken by central banks after the collapse of Lehman Brothers in 2008. The failure of such a large debtor to make good on its obligations threatened the capacity of many of the firm's creditors, themselves debtors, to meet their respective obligations. The potential ripple effects threatened to bring down the entire economy. We need not examine in detail the government response to the 2008 crisis. Suffice to say, this time, the worst seems to have been averted. However, the growing disparity of income become rich and poor, which has become worse still since 2008, will continue to put ever increasing stress on the financial system and central banks as economies are forced to create ever more elaborate and complex credit relationships to re-inject into the economy the huge sums of excess cash held by a super elite class of mega capitalists.
In sum, while it is indisputable that the massive government spending during the second world war and the post war reconstruction ended the great depression and brought on a two decades of relative global prosperity, I fear that long term sustainable growth will never be attainable without a more equitable distribution of income. Our present course which does not nothing to address income inequality will lead to a cascade of financial crises, growing in scope and complexity, as banks and financial firms are forced to create riskier and more interdependent credit relationships between households, firms, and a plutocratic elite. Meanwhile, central banks will come under ever increasing pressure as they are forced to constantly ease credit conditions to spur sidelined savings into profitable investment outlets. Central governments will become even more indebted as they try in vain to soak up all the excess savings by the endless issuance of bonds to both fund new projects and refinance old debt. The seas appear to be calming, and a debt deal in Washington seems likely. However, steering around the fiscal speed bump in January does nothing to change our trajectory towards the ultimate day of reckoning.
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