Friday, December 27, 2013

Third Quarter Growth: Please Ignore The Blip

Investment Thesis: Bonds are oversold, and stocks remain attractive.

Bond prices are falling while stock prices are rising. This reflects the market’s bullish interpretation of the 4.1% annualized third quarter growth revision. The market has taken that single data point and extrapolated it into a faster recovery. Faster recovery would mean higher corporate earnings growth, and higher inflation. Hence, stocks up, bonds down.

The market is wrong on both counts. The third quarter growth number was a blip in a long series of blips in both directions. The signal to noise ratio is low and anomalous. Most other signals point in the opposite direction: low money growth, declining money velocity, low nominal and real growth, low inflation.

Money supply growth has been falling for the past two years (from 10.5% to 5.5%, YoY), while velocity has continued its long downward march. Inflation remains dangerously low and nominal growth is stalled at a scarey 3.4%. Metals are capitulating, not an inflation signal. There is nothing on the dashboard to signal faster growth, besides the revised 3Q number.

Quarter-on-quarter growth has been very volatile, and continually reverses direction. It means nothing unless sustained, which I don’t expect. While it’s hard to get excited about 3% bond yields, there is nothing to suggest that yields will go higher; they are more likely to decline once the bleak reality asserts itself.

The stock market would seem to lack a compelling inner logic. It is forecasting both low inflation and strong earnings growth, which is an unlikely combination. I am expecting low inflation and modest earnings growth. The topline will remain under pressure from low nominal growth, while the productivity gains from the recovery are diminishing in scale.

My bull call on the Dow is not driven by earnings growth, but rather by the fact that one is still being paid more to own stocks--even at these prices--than to own cash or bonds. The forward earnings yield on the S&P is now 6.1%, which is twice the yield on the ten-year. Hence I see the S&P as still being fairly priced; not a screaming buy as in 2009, but still your safest bet.

I expect negative earnings surprises going forward, for the reasons given above. So, for example, if S&P earnings were to have a flat or negative quarter, prices would decline. That is the risk at this price-level. But I see nothing that would cause a sell-off, and there is still upside.

Sunday, December 22, 2013

Ignore 3Q Noise: Growth Outlook Still Bleak

Executive Summary
The growth outlook remains bleak, despite the third-quarter revision. However, stocks are still attractive.

I have been bearish on the growth outlook for quite awhile. On Friday, third quarter growth was revised upward to 4.1%, which is billed as “the strongest advance in nearly two years”.  Supposedly this is a signal for strong growth going forward.

My reaction? That’s nice, but I’m still bearish on the growth outlook. The revised growth number is the annualized rate of growth in the third quarter, i.e., the growth rate between June and September. Annualized quarter-to-quarter growth is highly volatile and often reverses direction. I don’t think it can tell us very much.

I look at the year-on-year growth numbers which give us the growth rate over twelve months, and provide a better sense of the economy’s longer-term trajectory. That data tells a very different story. On a year-on-year basis, third quarter real growth was 2% and nominal growth was 3.4%. I’ve been saying that you can’t have 4% real growth with 3-4% nominal growth, and I still say it: the economy needs 6-7% nominal growth, which requires 3-4% inflation, which isn’t happening under this Fed.

Five years after the Crash,  the economy remains in “low”: low money growth, low inflation, low nominal growth, low real growth, low employment growth. I would observe that YoY growth in M2 has recently fallen below 6%, its lowest rate of growth since mid-2011, and that PCE inflation is now 0.7%, its lowest level since the Crash (and 35% of the target rate). Employment growth has been stuck below 2% for the past two years. There are few bullish signals buried in the data. The one ray of sunshine is household deleveraging, which has finally ended. The Minsky cycle may be turning.

Investment conclusion
Stocks remain in value territory relative to bonds, but underlying earnings growth will slow, given 3% nominal growth. Negative earnings surprises are likely to begin to exceed positive surprises. Nonetheless, it would be prudent to remain highly exposed to US equities. The outlook for metals is bleak. The value of a hedge declines as the probability of the adverse event declines. The risk of an inflation surprise is low.

Wednesday, December 18, 2013

The Taper: Monetary Nonfeasance

The Fed’s long-awaited taper has finally begun.

Having added $1 trillion to its assets in 2013, and having failed to achieve either of its statutory mandates, the Fed has decided to reduce purchases while predicting eventual victory: “The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.” Not tomorrow, but someday.

And what about deflation risk, Bernanke’s  personal bete noir?  “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”  “Monitoring” will prevent deflation; that’s a new policy tool. Bernanke said today that “inflation can’t be picked up and moved where you want it.” This from the man who said that a central bank could always create inflation using the printing press.

It is noteworthy that, unlike Draghi who talks through all of the data including money growth, Bernanke does not. This saves him from having to explain why he has no control over money growth. Instead he repeats the line that the Fed is providing a “highly accommodative stance of monetary policy”. Which is actually not true, when we are looking at 6%  money growth, 1% inflation and 3% nominal growth. That is not a highly accommodative stance.

In point of fact, the Fed has been tightening for the past two years, with M2 growth falling from 10.5% to 6.0%, inflation falling from 2.0% to 1.1%, and nominal growth from 5% to 3% (YoY). QE3 has had no impact on money growth. At present, using its current policy instruments, the Fed has no control over the independent variables in the Quantity Theory: the money supply and velocity. This is why nominal GDP has been sliding sideways.

Where is Chairman-to-be Janet Yellen in all this? We don’t know. Bernanke says that she is on board with tapering, although I doubt it. I think that she is keeping a low profile until she takes the helm. Then we will find out what she really thinks.

I hope that Obama nominates Stanley Fischer* as vice chair, which would add a lot of heft to a weak team, and might add some firepower to the doves. He’s a monetarist, not an Austrian.  At MIT, he was the thesis adviser for Ben Bernanke, Mario Draghi, and Greg Mankiw. You can’t beat that!
*Who would be the first African native to sit on the FOMC.

Monday, December 16, 2013

Does Southern Europe Have A Central Bank?

There has been quite a bit of happy talk in the media about the “resolution” of the eurozone crisis. I’m not clear why, since Europe’s depression continues unabated. Real GDP peaked nine quarters ago, unemployment remains at 12%, and the debt ratios have not changed their trajectories. The ECB's own forecasts are grim. One is tempted to ask if the eurozone’s real output will ever return to where it was in 2011, given its current slope. And even more disturbing, nominal GDP growth has been flirting with zero. The eurozone economy has flatlined, like a corpse. The crisis isn’t resolved.

But you wouldn’t know this by listening to Draghi’s press conferences. He is satisfied that the ECB has done all it can in terms of stimulus, and that recovery depends upon further structural reforms. He says that “low growth is the outcome of economies that need to have structural reforms”, and that “structural reforms are the necessary and sufficient condition for recovery to happen”. He reviews the dismal economic statistics (and the ECB's dismal forecasts) at his press conferences, and then concludes by congratulating the ECB for achieving price stability, its single mandate. The fact that inflation is running well below its 2% target is not a problem, since that demonstrates even greater price stability.

By blaming the eurozone’s depression on structural deficiencies, the ECB has  washed its hands of Southern Europe: if the southern tier want growth, they will have to tighten their belts and wait for their domestic price level to fall until they become competitive. A few more years of austerity, and growth will naturally resume. As Irving Fisher said in 1933, "This is the so-called 'natural' way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

Barry Eichengreen*, an expert on the subject of the Great Depression, has accused the ECB’s of having abandoned its core responsibilities as a central bank. In his view, structural reforms or the lack thereof are irrelevant and beyond the remit of a central bank, and cannot justify the abdication of a central bank’s responsibilities as protector of the payments system, guardian of financial stability, and lender of last resort.

Eichengreen lays out the devastating data: “The numbers are alarming. Core inflation fell to an annual rate of 0.8% in October – a 47-month low – while producer prices fell by 0.5%, suggesting that deflation is already in Europe’s economic pipeline. Annual growth of M3 money supply, meanwhile, dropped to 1.4% in October, from an already dismal 2% in September, while loans to the private sector contracted by 2.9% year on year.”

He blames this state of affairs on the ECB’s deference to German public opinion:
“A responsible central bank should not cater to irrational fears of inflation in what is in fact a deflationary environment, just as it is not an independent central bank’s role to tighten the thumbscrews for fiscal and structural reform.”
He deplores the ECB’s decision to condition the performance of its core responsibilities on compliance with EU conditionality: “While a central bank should ensure the smooth operation of the payments and financial system, it makes no sense for this task to be contingent on governments’ negotiation of a reform program with the European Union. The commitment to preserving the integrity of the payments system must be unconditional. If the ECB concludes that panicked investors are threatening the integrity of the payments system by selling a member state’s bonds, then it should intervene, buying up those bonds on the secondary market, EU agreement or not.”
He is concerned that the ECB’s focus on German opinion is leading to a deflationary spiral: “It is reasonable for the ECB to be concerned about its public standing. But if its leaders are worried about the impact on its reputation of embracing unconventional policy, they should pause and reflect on the much greater damage that would follow from allowing the economy to slip into a deflationary trap from which it would be difficult, if not impossible, to escape.”
Needless to say, the ECB does not agree with Eichengreen’s diagnosis nor with his prescriptions. The ECB believes, instead, that its has been providing “extraordinarily accommodative” policy since the Crash, and that this policy is working. The ECB is also of the view that the preservation of the euro and the eurozone does not, will not, and cannot require the ECB to rescue individual countries or banks. They must save themselves by “bailing in” bondholders and uninsured depositors (in other words, default). That’s the ECB’s response to being asked to act as the lender of last resort.
Eichengreen is worried that a eurozone deflationary spiral would be difficult to reverse. Europe only has two economic levers: monetary and fiscal policy. Ideally, these levers would be pulled in concert: the ECB would monetize fiscal deficits, thus increasing aggregate demand and inflation. But the ECB has forsworn both tools by demanding fiscal balance and prohibiting “monetary financing”. Both levers are locked in the ECB's closet. If deflation does gather momentum, the ECB will have no tools to fight it.
I have argued that, in the end, the authorities in developed countries will always choose financial stability when forced to do so by a crisis. I am beginning to think that this may not apply to the eurozone. The restoration of financial stability in a crisis requires the provision of unlimited liquidity by the central bank, and the support of a credible and responsible guarantor. When the US financial system was rescued five years ago, nobody worried that the Fed would withhold liquidity, or that the Treasury could not afford to recapitalize the banks. Everyone knew that the Fed had a printing press, and the US Treasury unlimited debt capacity. Once the TARP was up, the death spiral was stopped.
The ECB is not acting as the central bank for troubled countries in Southern Europe; it is acting more like the IMF, a provider of conditional assistance. Further, there are no credible guarantors in the eurozone. Germany is too small, unwilling, and not responsible for the rest of the zone. The ESM is tiny. Thus Europe lacks an effective central bank and a credible guarantor. Indeed, we have already witnessed the collapse of the financial system of one of the Southern European countries, which occurred with the knowledge and approval of their so-called “central bank”.
Who will be next and what will happen to them? Under the Single Resolution Mechanism, depositors at all eurozone banks are at risk of default, conditioned on the financial resources of their governments. What stands between the next wave of insolvencies and financial collapse? Not the ECB.
*Barry Eichengreen is Professor of Economics at UC Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is “Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System”. He has written extensively about the interwar gold standard. The piece from which I have quoted is “The ECB’s Bridge Too Far”, Project Syndicate, 10 Dec. 2013.

Saturday, December 14, 2013

Municipal Bankruptcy: The Endgame?

Muni credit can be interesting, and its getting interestinger by the day. At present we have a good number of muni credits which are grappling with unwieldy unfunded pension liabilities, either in or out of bankruptcy. There are many forces at play. The political cards are generally stacked in favor of pensioners and against bondholders, insofar as politics matters. (It used to matter in Detroit, but no longer.) More crucially, in some states, public pensions are constitutionally protected, whereas bondholders are left out in the cold.

A federal judge recently ruled that Detroit’s pensions are subject to the Federal Bankruptcy Code, even though protected by the Michigan Constitution. The pro argument is that Federal law always trumps state law; the con argument is that Chapter Nine defers to the states in the governance of bankrupt munis. Don’t think about this issue! It will be decided by SCOTUS soon enough.

Regardless of the outcome of the who-trumps-who question, we are already learning that the sacrosanct General Obligation claim is effectively unsecured in bankruptcy, and subject to cramdown. Those speculators who bought junk GOs in the belief that GOs always get paid are going to be disappointed, and no one will cry for them. (It will mean, however, that deadbeat munis won’t be able to sell any more GOs, at least to the mentally unimpaired.)

But, as a thought experiment, let’s assume that SCOTUS decides in favor of the pensioners, for whatever reason. And let’s also assume that the bondholders also get something in the final settlement, such that the bulk of the city’s liabilities are not extinguished. Or, alternatively, that some cities are not permitted to go bankrupt, like Harrisburg. Either way you get a situation in which a dying city with an incurable structural deficit is saddled with most of its legacy obligations, with no way out. What then?

One might suggest that such cities could be rescued by their states, as NYC was rescued by NYS in the late seventies. And that could happen in states where the city and the state are both controlled by the same political party, like Illinois (if Illinois had any money to spare, which it doesn’t). But where the city and state are controlled by different parties, like Detroit and Harrisburg, there will be no state bailout. What then?

I can only imagine that those cities will have to go the way of Carthage (North Africa, not Illinois). They will have to disappear. We have already seen this process in a number of cities with evanescent tax bases. But never in a big city like Detroit or Chicago, or a big territory like Puerto Rico. It seems to me that instead of having monorails and and electric sidewalks, the City of the Future may be an empty wasteland.

Monday, December 9, 2013

Why China Behaves So Badly

Western observers say that China’s behavior is "puzzling", and that its policy goals are "enigmatic". In fact, China's behavior is neither puzzling nor enigmatic; its behavior is shrewd, pragmatic and realist. China’s internal and external behavior can be explained once one grasps that China is a rational actor operating under enormous economic pressure.

Below are some of China’s sins against the "international community":
>UN obstructionism on many important matters such as nuclear proliferation;
>Jingoist, xenophobic ideology at home and abroad;
>Pursuit of regional hegemony, bullying regional neighbors;
>Support for the evil Kim regime and its multitude of international provocations;
>Militarism, military buildup, military threats;
>Authoritarian domestic policy;
>Abysmal human rights record: Tibet, Uighurs, Falun Gong, prison factories, etc.
>Currency manipulation;
>Threats to stop buying US Treasuries and to dump the dollar;
>Unfair trade policies, mercantilism, flouting of WTO;
>Massive intellectual theft.

All of this behavior can be explained.

China was a filthy dirt-poor agricultural nation of half-starved peasants when Chairman Mao died in 1976. Looking at China’s weak position in the world at that time, Deng Xiaoping made the decision that a poor China could not be a strong China. Under Deng's leadership, the CCP launched a program of export-led industrialization which has continued uninterrupted to this day. Like Japan's a century earlier, China’s modernization proceeded at a rapid pace. Starting with modest experiments in Guangdong and Shanghai, China quickly built an industrial economy that is now the second largest in the world, and will soon be the the largest. The success of Deng’s plan has been nothing short of amazing.

The CCP’s plan then and now was to free China’s one billion peasants from the poverty of low-productivity agriculture, and to channel this bottomless reservoir of low-cost labor into manufacturing. The overarching challenge is to match the constant inflow of low-skilled peasants from the west with the creation of new manufacturing jobs in the east. This is no small task: it requires rapid real growth year in and year out, and massive infrastructure investment. As the model is export-led and focused on manufacturing, it requires ever-higher manufactured exports. And therein lies the world’s “China Problem”.

China’s manufacturing potential is so huge that within a few decades its output could exceed that of the the rest of the world combined. The world's central problem is that China is simply too big to be neatly inserted into global trading system. When countries like Guatemala or Bangladesh seek to grow exports, they can do so without affecting markets or hurting competitors. By contrast, China at its full potential is a Panzer tank at Tiffany’s. For China to succeed in implementing its development plan, it will have to destroy the world. China’s national development strategy compels it to wreck everyone else’s manufacturing economy. This is economic warfare, with Chinese characteristics.

China has succeeded in massive export growth without currency appreciation by an idiosyncratic set of economic policies. China has ignored virtually all of the self-serving economic precepts of the West, which prescribe open capital accounts, elimination of currency controls, and freely-floating exchange rates. It was this suicidal advice that caused the East Asian financial crisis of 1997-98, which China survived unscathed.

China’s more prudent policy has been to: maintain very large external reserves; impose capital and exchange controls; peg its currency to the (weak) dollar; and mop up currency inflows and park them in the reserve account. No manufactured imports, thank you, just exports and an ever-greater reserve mountain. This unorthodox policy has enabled one of the greatest growth stories in modern economic history.

So, an American will scratch his head and ask: Why does the US allow China to undersell its manufacturing sector, and to capture entire markets? How can the US permit the price of its unskilled labor to be globalized? What are American high school graduates supposed to do for a living? Why doesn’t the US impose punitive tariffs as punishment for China’s mercantilist policies? The answer to these questions is that China has used a variety of geopolitical maneuvers to keep the West off-balance and confused.

China simply cannot allow the West to focus its attention on China’s trade policies. She must do whatever it takes to distract, confuse and otherwise change the subject. China has a myriad of geopolitical levers at her command to divert the world’s attention. (which I have listed above). 

The more  trouble China creates, the more the West is distracted. When Joe Biden flies to Beijing to talk about trade, China declares an air defense zone in the East China Sea. What does Biden end up talking about? The air defense zone; trade policy is forgotten. The ADIZ crisis was manufactured to prevent trade negotiations.

China explains its international behavior as anti-hegemonist, but that is a smokescreen for self-interest. China doesn’t care very much about peripheral things like Sudan, Iran or the Middle East; what she cares about is international leverage. When western leaders huddle to discuss the latest crisis, what do they usually end up talking about? How to get China to cooperate with the "international community". The inevitable upshot: someone flies to Beijing to beg for China's help. The small price to pay for China's "help": ignore China's trade surplus.

The EU wants to talk about non-tariff trade barriers? China arrests some hapless poet, which changes the subject. Other available “negotiating” tools: launch a new weapon; stake a new territorial claim; foment anti-Japanese protests; have North Korea shoot a rocket over Japan, or shell a South Korean fishing village. China explains much of its antisocial behavior as a response to domestic "public opinion"--which she manipulates at will. Chinese nationalist fervor serves the state, discourages dissent, and prompts Western “concern”: providing yet another reason not to press too hard on trade. North Korea is just an extension of this policy by proxy.

China pursues a policy of provocation, poking at the rest of the world, particularly the US Congress. Do you want to prevent Iran from going nuclear? Do you want peace in the East China Sea? Do you want to have influence over the Kim Dynasty? Do you want internet freedom? Do you want a free Tibet? Do you want to sell your country’s products in China? Then you must go to Beijing and beg. Begging is your only leverage; pleading is your only strategy.

I offer above an explanation for China's bad behavior. I can also suggest a solution: impose tariffs on Chinese exports. If China retaliates by selling dollars and Treasuries, she will have done exactly what we desire: America needs a stronger yuan, a weaker dollar, and a revived manufacturing sector to employ our unskilled labor. As a society, we cannot allow the price of our unskilled and semiskilled labor to be globalized. (Raising the minimum wage only makes China more competitive.)

Another benefit to "fair trade with China" is that, by wielding a big stick (tariffs) and playing the international bad boy, America regains geostrategic leverage beyond trade policy. All of a sudden, the Politburo would have to worry about America’s behavior. Problems such as North Korea would become more tractable.

But what about America’s treaty obligations under WTO? A “fair trade” policy involves what is known as “national treatment”: we will trade with you as you trade with us. To confront China's realpolitik, the US needs to start thinking and acting like a normal country which protects its own interests and makes no pretensions otherwise.

Sunday, December 8, 2013

Obamacare: The Policy and the Politics

Note: A number of readers have suggested that I enlarge my topical universe to public policy matters beyond finance: I will attempt to comply. Let me know if you think this is a bad idea.

On a policy level, there are things to like about Obamacare: it heads in a number of helpful directions.
The current healthcare system has many flaws: (1) the consumer has little incentive to limit his consumption; (2) the employer model does not work well in a fluid labor market; (3) the individual insurance market is expensive and uncompetitive; (4) there is a large cohort of low-income people who need a subsidy to afford health insurance; and (5) there are many unwell people who cannot obtain affordable health insurance. Obamacare addresses each of these problems.
Better consumer incentives
Obamacare will push people into plans with high deductibles and copays. This will provide the consumer with strong incentives to shop on the basis of price, and will force providers to disclose and compete on pricing. It will also limit excessive healthcare consumption.
Moving away from the employer model
There is no reason why employer-provided health insurance is not taxed as regular income, nor is there a good reason why affordable insurance should be linked to employment. Although ACA does not end the tax-free treatment of employer insurance, it will lead many employers to push people off of group plans and into the exchanges, where they can buy portable policies. Over time, this will reduce the cohort who obtain insurance through their employers, and will make individual insurance more affordable, and increasingly the norm. (The tax treatment of health insurance and the employer linkage will have to be addressed in the future--the distant future.)
Lower cost of individual insurance
The larger the number of people shopping for individual insurance, the larger the risk pool and thus the lower the cost. The exchanges are intended to force  the insurance companies to compete on price, which should also force providers to compete on price. (There should be a national health insurance market, but that was a bridge too far for the insurance industry, which desires multiple barriers to entry.)
The uninsured
There are many people who need but can’t afford individual insurance. The premium subsidies will help.
The sick
By ending underwriting on the basis of expected claims, Obamacare will make affordable insurance available to those who are already sick. This is really a subsidy not insurance but the cost of sickness should be socialized since it is not a choice.

Over time, these policies should have the benefits of making healthcare cheaper and more available. On balance, I think that Obamacare is good policy, so long as one believes that healthcare and health insurance fall within or should fall within the federal penumbra. 
I take the legal view that the founding compact was explicitly intended to prevent a federal Leviathan; and I take the policy view that the Constitution is correct, in that the European social model is bad policy on a number of levels: incentive structure; equity; private property; national character; economic growth; the benefits of free market competition. That’s for another blog. Now to the politics of Obamacare.

The central political debate today between left and right is about the size and scope of the welfare state: do we want the US to adopt the European “social model”, or do we respect the idea of limited government?  Democrats desire the European social model; Republicans want limited government. Obamacare is an expansion of the social welfare state, and thus the latest battle in this 100 year-old war.
Crudely put, the European social model creates political constituencies with subsidies, such that voters receiving such subsidies will vote for the party that dispenses them (see: France). Politically, Obamacare was conceived as another such subsidy: a way to add millions of new government dependents, and thus create another constituency for the Democratic Party.
The Democrats told middle class voters that Obamacare would reduce their healthcare costs and would be paid for by others: insurance companies, doctors, hospitals, and “the rich”. The Democrats saw saw Obamacare attracting many new Democratic voters--and so did the GOP. They were both wrong.

We now know that both parties got it completely backwards. It was already accepted dogma that Social Security and Medicare reform were politically toxic. It should also have been obvious that healthcare is another “third rail”: my premium, my deductible, my copay, my policy, my doctor, my hospital, my children. The Democrats are slowly coming to the realization that changing voters’ healthcare arrangements is bad politics, even if it is “good for them” in the long run.
In  retrospect, it is important to remember that ~85% of Americans were satisfied with their healthcare arrangements, and that most of Obamacare’s would-be beneficiaries were already within the Democratic demographic. Even had the law been rolled out perfectly, Obamacare would in all likelihood have created few new Democrats, and many new Republicans. The botched website and the 5 million cancellations served to focus attention on the law and its larger implications for middle class families.
For any healthy voter who makes more than the subsidy cut-off, Obamacare will generally make health insurance more expensive (higher premiums, copays and deductibles). The electoral demographic which is going to have to pay more is not just the rich, but also the middle class, and the middle class has begun to discover this fact. For example, Anthem Blue Cross in California received a recent letter from a woman complaining about a 50% premium hike who wrote, “I was all for Obamacare until I found out I was paying for it”. She and many other voters thought Obamacare would be free to them, like an EBT card.

Giving voters free entitlements is politically popular. By contrast, cancelling policies, forcing employers to drop health insurance, raising premiums and deductibles, limiting doctors and hospitals, forcing people to renew their policies under a government template: these are politically unpopular. That should have been readily anticipated (by both parties) when the law was being written.
Today, many are asking how President Obama and the rest of his party could have stated repeatedly that ACA would not cause those who like their insurance policies to lose them. I don’t think that this was a conscious lie on anyone’s part; I think rather that the Democrats in Congress and the White House didn't understand the full implications the law: they had to implement it to find out what's in it. That was political negligence: they paid too much attention to getting it passed, and too little attention to its practical impact on middle class families. They also chose to pass the law without a single Republican vote, which means they now own it politically.
Juan Williams (FNC) was recently  invited to the West Wing to discuss the Obamacare rollout. After the meeting he said: “What you hear from these senior officials is that they wish the insurance companies hadn't sent out the cancellation notices.” In other words, the senior officials were not aware that this was going to happen. That was a fatal blunder, particularly because so many Democratic congressmen and senators were told to repeat this falsehood. They got no heads up about the five million cancellations, which is why they (and Obama) are so angry at the policy munchkins.
As it has turned out in practice, everything fabulous that Nancy Pelosi expected and everything awful that Ted Cruz feared has not happened. Instead of creating a new constituency for the Democrats, Obamacare has revived the electoral prospects of the GOP.

I would not conclude that the fate of Obamacare represents a shift by the middle class voter away from new entitlements. So long as they are believed to be "free", voters will take them. What Obamacare shows is that any attempt to reform something as personal as healthcare is dangerous, as Bill and Hillary Clinton learned to their detriment in 1994. The political lesson of HillaryCare was not “Keep at it”; it was “Don’t go there.”

Friday, November 29, 2013

Bitcoin: The Future Of An Illusion

“John Law's pioneering note-issuing bank thrived until the French government was forced to admit that the number of paper notes being issued by the Banque Royale were not equal to the amount of metal coinage it held. The bubble burst at the end of 1720, when opponents of the financier attempted to convert their notes into specie en masse, forcing the bank to stop payment on its paper notes.”--Wiki

Now that the price of a Bitcoin has been bid above $1000, I cant ignore it any longer. It begs for comment from financial bloggers*.  Just this month, Bitcoin has gone from $200 to $1200, reportedly due to Chinese demand. Bitcoin has achieved price parity with gold and Google.** 

Bitcoin's literature has grown apace with its price. There is no end to how much you can read on the subject. I will not be devoting my life to reading the Bitcoin oeuvre. But I've read enough to have an opinion, which hasn't changed since I first heard of the phenomenon.

Bitcoin promotes itself as a superior currency to the fiat dollar. Its adherents believe it to be a “disruptive technology” that will ultimately supplant obsolete and discredited fiat currencies. It has been called “the internet of money”***. Bitcoin is the platonic ideal of a currency, free of the encumbrances of antique financial folkways. It comes with its own anti-statist ideology. It is, to use the latest cool word, “transgressive.” It appeals to rebels, those who think outside the box. The FT says that believers see Bitcoin as “purposefully designed to disrupt and destabilise the current economic status quo.” Like gold, Bitcoin has religious overtones.

Should you doubt me about the religious element, read the invective from the metallic and Bitcoin communities when someone dares to cast doubt on their belief system. The response is hostile and ad-hominem. There is no room for rational discussion.

I have seen enough of similar investment vehicles in my lifetime to be able to say with confidence that Bitcoin is another speculative bubble. There is a old story about canned sardines in China, which were being traded up to ever-higher prices. A skeptic opened one of the cans and found nothing but maggots. When confronted, the dealer explained “these sardines are for trading, not for eating”.

Dutch tulips, French bank notes “backed” by gold, Mississippi Company stock, South Sea Company stock, canned sardines, Ponzi, RCA, conglomerates, pyramid schemes, internet stocks, Beanie Babies, mortgage securities, precious metals--you name it, the instruments of speculation will always be handy for the greedy and the ignorant.

Bitcoin believers say that that because Bitcoin has gone up in price, that proves it’s not a bubble. Of course, it would not be a bubble unless it went up in price. The fact that a speculative instrument has risen in price is not indicative as to whether it is a bubble or not.

How can we distinguish between, say, a Google stock and a Ponzi scheme? After all, GOOG is an internet investment that has also gone up to $1000. The answer is fundamental analysis. GOOG may have speculative elements, but it is also a highly profitable and rapidly growing monopoly, which distinguishes it from many other internet stocks. GOOG may decline in value, but it isn’t likely to go to zero, like Beanie Babies or Global Crossing or Enron. (Gold is also unlikely to go to zero.)

The theory behind Bitcoin is that the ultimate supply is finite, at 21 million. As it grows in acceptance as a medium of exchange, it will rise in dollar value, much as gold has in the last 80 years. As one believer says:
“The true value will come when the technology and acceptance become pervasive, and Bitcoin evolves into a primary technology that a world of application, payment and otherwise, is built upon. People with knowledge and insight (the list of renowned technologists and economists is growing) are supporting it due to the real possibility it could become a dominant technology.”

If indeed a meaningful volume of retail trade were to be conducted in Bitcoin, demand for liquidity balances would likely drive up the dollar price to a level much higher than where it is today. Is in fact Bitcoin’s share of retail trade growing? Possibly, but I still say it’s a speculative bubble. Liquidity demand is not driving up the price; Chinese speculators are.

The important thing to remember is that, according to a recent UCSD study, most of the demand for Bitcoin is speculative, and not for use as a medium of exchange. Growth as a medium of exchange would create real persistent demand; speculative demand, by contrast, fluctuates.

Bitcoin is an unofficial currency; it is not regulated, nor are its “banks” regulated. When it blows up, there will be no one to blame or to sue. It is based entirely on anonymous trust. And therein lies its central fallacy: fiat currencies are bad because you can’t trust national central banks, but cyber currencies are good because you can certainly trust unnamed strangers with no fiduciary duty, no regulation, no balance sheet or street address.

Permit me to list some of the rather useful attributes of the dollar, and the less useful attributes of the Bitcoin:

The Dollar
1. Its supply is a known quantity disclosed at regular intervals by the Fed.
2. It is legal tender and it can be used to buy anything and to settle all financial transactions.
3. Dollar purchasing power stability is a Fed mandate.
4. Dollar bank deposits are federally guaranteed.
5. Bank robbery is a federal crime.
6. As a medium of exchange, it can take the form of cash, a debit card, or a credit card.
7. Consumer credit card fraud losses are limited by law.
8. The dollar’s value in dollars is stable.
9. Counterfeiting dollars is a federal crime.
10. Dollars can be readily obtained and exchanged for other currencies.
11. The dollar is highly liquid and fungible. Its price never changes, and virtually every good and service in the US can be bought with it.

The Bitcoin
1. Its supply is based on a promise; there is no official data.
2. It is not legal tender, and no one is obligated to accept it.
3. The minters of Bitcoin make no promises with respect to stable value.It fluctuates in nominal and real value.
4. Deposit balances are held by unregulated private entities with unknown addresses or financial strength.
5. Cyber-theft of Bitcoins is not a top priority at the FBI.
6. As a medium of exchange, it can only take the form of unregulated cyber credits and debits.
7. Fraud losses are to the account of the holder alone.
8. The Bitcoin’s value in dollars fluctuates.
9. Counterfeiting Bitcoins is not a federal crime, although it might someday come under wire fraud.
10. Bitcoins are quite hard to acquire and difficult to exchange for other currencies.
11. Bitcoins are illiquid; the price-discovery process is highly inefficient; there is no central clearinghouse; only a limited variety of goods and services can be bought with them.

To conclude: As a store of value, the Bitcoin is purely speculative. As a medium of exchange, it is inferior to the dollar and its modern derivatives. As a unit of account, it belongs with Beanie Babies and unlisted stocks. There is no saying how high Bitcoin's price will go; its future price is a random walk, ending at zero. All we know is that, at some point, it will crash.

Tidbits from the media:
>A British man says he threw out a hard drive that had 7,500 bitcoins on it, worth over $7.5 million as of Wednesday.
>The ECB has looked into the “threat” from Bitcoin and concluded: “It is mostly the holders of the currency that face risks, including the risk of a complete loss of the monetary value."
>The general consensus is that Bitcoin mining will have approached a point where only those with access to free or cheap electricity will continue operations, and even they will produce a relatively marginal return on investment, rather than the huge multiples possible even earlier this year.
>Every participant in the system must keep a copy of the block chain, which now exceeds 11 gigabytes in size and continues to grow steadily. This alone deters casual use.
>Even the largest Bitcoin Exchanges have been subject to operational interruption by hackers and/or malware, limiting the liquidity of Bitcoins on the Bitcoin Exchange Market and resulting in volatile prices and a reduction in confidence in the Bitcoin Network and the Bitcoin Exchange Market.
>The Winklevoss twins are screaming bulls on bitcoin. Cameron and Tyler Winklevoss—big investors in the digital currency—said Tuesday that Bitcoin should be worth at least 100 times more than it's valued today. "The small bull case scenario is a $400 billion market cap. So the market cap is around $4 billion right now," Tyler Winklevoss said in an interview.
>If a malicious actor or botnet obtains control in excess of 50% of the processing power active on the Bitcoin network, such actor or botnet could manipulate the source code of the Bitcoin network or the blockchain in a manner that adversely affects an investment in the shares or the ability of the trust to operate.
*If you want to read about Bitcoin, I recommend the Bitcoinmania Series written by Izabella Kaminska at FT Alphaville; she is on the case and has decidedly not drunk the Kool-Aid.
***  “Bitcoin is a fixed supply, a first-of-its-kind, global-in-scale, voluntary, decentralized open-source digital currency and payment network that enables direct, peer-to-peer, borderless, pseudo-anonymous, nearly-instantaneous, nearly-free and irreversible cash-like transfers of value. The first currency and money system in the world which has no counter-party risk to hold and to transfer. Instant transactions, no waiting for checks to clear, no chargebacks (merchants will like this), no account freezes (look out Paypal), no international wire transfer fee, no fees of any kind, no minimum balance, no maximum balance, worldwide access, always open, no waiting for business hours to make transactions, no waiting for an account to be approved before transacting, open an account in a few seconds, as easy as email, no bank account needed, extremely poor people can use it, extremely wealthy people can use it, no printing press, no hyper-inflation, no debt limit votes, no bank bailouts, completely voluntary. This sounds like the best payment system in the world!”
--Bitcoin believer at Reddit/bitcoin.