I apologize that I have not written sooner. The last 8-9 months have been long and have required my full attention; from setting up new offices, new jurisdictions, new businesses, accounting, systems, new language, traveling, and of course legal. Seems like I have little time for anything right now, but there is a light at the end of the tunnel and I see fruit starting to bare for my efforts. Meanwhile the market has remained in a relative volatile range, not knowing whether to rally or sell-off. Yet, we seem to be facing an unprecedented time, much like in 2008. What was once absurd is becoming the norm and the question I ask myself as I rise each day, “what’s the next level after absurdity?”
I take time out of my schedule to write today’s preview, because it was triggered by a small story that received almost no press: “Yellen says Fed purchases of stocks, corporate bonds could help in a downturn!”
For someone like myself, that is not only a warning sign that negative interest rates are on the horizon, but we are about to move further down the rabbit hole of unprecedented Fed monetary policy.
Her statement is shocking, “If we found, I think as other countries did, that they could reach the limits in terms of purchasing safe assets like longer-term government bonds, it could be useful to be able to intervene directly in assets where the prices have a more direct link to spending decisions.” She added that buying equities and corporate bonds would have benefits.
Let me sum that up for you. “If the Fed reaches the limit of buying government bonds, sending them into negative yields, we could start buying stocks and corporate bonds to get the economy going!”
So negative rates are coming and next up will be (like Japan) buying stocks and corporate bonds. As I have said for years, watch Japan because we are following in their footsteps.
I have been fortunate, or unfortunate, to bear witness to several significant market crashes, black swans, jolts, and a smattering of volatile events since the early 1990s. In most cases standing right in the belly of the beast on the trading floor itself. Watching it unfold around me in chaotic fashion is certainly awe inspiring. I remember times leaving the trading floor emotionally and physically drained and my voice sounding like I just smoked 10 packs of cigarettes after yelling for hours on end. You leave if almost dazed, not knowing what tomorrow will bring. Unfortunately, these events don’t come that often, for there is money to be made. On the other hand, fortunately they don’t come that often because I don’t know if one can stand such constant emotional and physically exhaustion that it takes and the heavily toll. I make this point, because I am ready for the potential chaos that may ensue and expect to profit from it, not because I hope for economic duress, but if it is to be expected one should position themselves for such an event. Opportunity can be found in the most dire situations.
Courtesy of SFGATE
The Basics of Economics
I must preface today’s preview with a basic primer of economics, to lay the ground work and for one to understand my deeply rooted concern of what lies before us.
There is one force that rules all civilizations since the dawn of time, that force is the Law of Supply and Demand. We can’t change it, ignore it, wish it away – its very nature determines whether a business and even a nation is prosperous or fails.
If we divide the world into two groups; Supply (the producers) and Demand (the consumers) we would see something unfold over the last few decades that is rather concerning. The Demand (consumer) nations, predominately the West, is in a never ending cycle to chase economic growth via consumption rather than production. The trade deficits continue to widen as the West consumes far more than it produces. The West is focused on consumption growth only, and they have collectively turned almost exclusively to debt consumption.
Courtesy of wikipedia
Our own Federal Reserve, whose Keynesian economic model, is the core of this radical belief system. Rational and logical arguments can be made for the use of TEMPORARY debt to spur growth in a business and perhaps even an economy (during a time of need). However, for debt formation to be the core methodology to grow an economy is venturing down the road of failure. Eventually one reaches a level in which it is virtually impossible to maintain debt financing. I had wrote about this at length about GM and predicted their collapse, simply by looking at their borrowing vs. revenue (their ability to finance debt). Once GM borrowed money just to pay INTEREST on existing debt, the game was over. It was only a matter of time before it failed. This is just simple math, one doesn’t even need a PhD in Economics to figure that out.
I recently spoke at the IOX 2016 event in Puerto Rico on this very subject. The problem in Puerto Rico is a micro version of what ails the U.S. and the Western nations, quite simply they are NOT producing as much as they are consuming. While I think the U.S. will have a hard time turning its own ship around, Puerto Rico has a chance to make huge strides moving into an export led (producing) economy in the next decade. That was the focus of the IOX 2016 event and one I firmly believe in.
Why does it matter?
Today the Fed and most politicians in general, have ignored this incredible force in civilization (Law of Supply and Demand). The Fed and our government are myopically focused on “jump starting” the economy by trying to stimulate consumption. This is the very core idea of Keynesian Economic theory – to paraphrase the theory in simple terms:
To get the economy to grow, people must spend!
The problem with that theory is it begs the question, where will the money for this spending come from?
Lord Maynard Keynes, the father of Keynesian economics, believed the government could inject stimulus (print more money, lower interest rates, create government work projects to create jobs, etc.) His theory almost ignores the Supply (production) side of the equation, since it places consumption (spending) above production. Of course Lord Keynes did famously say “In the long run we are all dead!” So I guess it doesn’t matter if we go into massive debt and fail, because in the end we are all dead anyway – why worry about it? Hope he didn’t have any grand-kids.
Courtesy of wikipedia
Regardless of political ideology, today’s politicians expound rather idiotic economic ideas. I chuckle when I hear a politician say something like, “We tried Supply Side economics and it doesn’t work!” What they are saying, is producing goods and services to create jobs doesn’t work and we need government stimulus to get people to spend and grow the economy. They will not, nor cannot, answer where this money is going to come from to stimulate. Some say, raise taxes on businesses and the rich, which seems like a self-defeating proposition – especially if they ignore the production problem, that creates jobs and business in the first place. You can’t tax people and companies, if there are no people and companies to tax.
There is one thing that Trump is right about – that is the massive loss of REAL jobs in this nation as companies move abroad. We are seeing a decline of PRODUCTION. Ford just announced it is closing another plant and moving to Mexico. We need to incentivize business to stay and new ones to come. Again, we must address the needs to boost production.
2000 – Dot.com bubble
I was living in San Francisco in the 1990s as a trader on the exchange. Most of my friends either worked on the trading floor or for one of the many Dot.com companies. The Dot.com boom was driven by debt. Companies with no revenue raised and borrowed 100s of millions of dollars. Many were racing to IPO and ignored the fundamental realities of business, which is production. Looking back on it, the absurdity of what Dot.com investors, employees, and founders would say was utter nonsense and absurd – “It’s about aggergated eyeballs!”, “We don’t need revenue, we need web traffic!”, “We create value and are a take-over target!”, “Our C round of funding will help us grow to reach that next round of funding!”. However, when you are surrounded by it and everyone is drinking the same Kool-aid and all “seems” well – you begin to accept this alternate reality, regardless of how absurd it is.
The Dot.com industry was a bubble, both the private and public sector. If one just looked at the simple equation that rules ALL business: Revenue – Costs = Profit or loss, it was simply ignored. Many of the publicly listed companies were trading at crazy P/E ratios and multiples – none of them made sense, yet people tried to justify them. In the private sector, I knew many companies that didn’t have a single penny of revenue, yet raised 100s of millions.
Courtesy of wikipedia
I don’t want to excuse the importance or the validity of the internet boom or the technology, my criticism is solely based on the valuations. “Irrational Exuberance” (a quote made famous at the time by Greenspan) had explained everything. New economist and young analyst were all trying to explain this NEW ECONOMY – and none of it was based on math, logic, or reason. If you didn’t understand the “New Economy”, then you just didn’t get it.
When it came crashing down it shattered the San Francisco Bay Area, almost everyone I knew in the Dot.com industry lost their job (unless you were actually a programmer). There was so many people leaving, that at one point you could NOT rent a U-Haul that was heading OUTBOUND. For all the hell the Dot.com bubble caused, it was for the most part isolated to those that invested and worked in the new internet market sector. However, the lesson was clear – debt formation bubbles have limited life spans.
2008 – Housing Bubble
After the Dot.com bubble the Fed, under Greenspan took rates down from 6% to 1% to spur economic activity. Following the Keynesian play-book, the idea was that lower rates would spur borrowing and therefore spending, in hopes that it would generate economic growth.
The Keynesian plan worked, the low rates spurred massive debt spending which continued to accelerate. One of the fastest growing industries was real-estate. The low rates created a new investment scheme, “house flipping”. House flipping only works in very low rate environments; the reason being is you need to carry a huge amount of debt for a period of time (from the moment you buy until you sell).
The core problem with house flipping is that there is no income generation, you are caring debt and speculating on the rise in price to make back not only your principal investment, but also the interest paid. Anything over that amount was a profit. If we looked at the finances of the house flippers, we quickly see their inability to carry debt for extended periods of time, the risk was very high. Any change (rise) in interest rates or home valuation and they would be quickly wiped out. According to Minsky, this was Ponzi Financing. (see post Minsky Moment)
Courtesy of wikipedia
The U.S. saw the largest rise in leverage debt in its history. This time it was not relegated to one sector like the Dot.com bubble, but across the U.S. and into every demographic in this nation. Much like the nonsense I heard during the Dot.com bubble, the same Kool-aid drinking silliness talk continued: “Housing prices never go down!”, “80/20 interest only means you don’t need money to buy a house!”, “A good house flipper can ALWAYS flip for 20% in 20 days, if they know what they are doing!”. Everyone was an expert. Housing flipping shows popped up on TV faster than new reality shows. It was just absurd, but everyone was drinking the Kool-aid and it would last forever – or so they thought.
The Fed tried to slow it down and raised rates from 1% back to 6 %. While it did slow, the damage was done the massive amount of debt was already in the system. It was only a matter of time.
The system imploded under its massive weight of leveraged debt. Nothing could or would stop it, it was just basic math.
The bursting of the housing bubble and dot.com bubble are one in the same. Huge leverage debt and the inability to finance debt for any length of period. Just like when the dot.com stocks declined that were purchased on margin that generated massive losses, the housing market declined that were purchased on mortgages that generated massive losses.
The dot.com and housing bubbles were able to form because the Keynesian method of lowering rates to accelerate (and one could argue encourage) debt spending worked. Yet it ONLY worked because consumers did NOT already have excessive amounts of debt. They had “room” to take on more debt.
Unfortunately for most Keynesians, just like they don’t consider the supply side of the equation in the Law of Supply and Demand, they also never consider the borrower’s CURRENT ability to borrow. Do borrowers have capacity? Can borrowers assume debt? Those types of questions are never asked by Keynesian economist. The assumption is – they can always borrow more.
After the bubble burst in 2008, the Keynesian Fed did exactly what Greenspan did in 2001 after the Dot.com bubble burst, they cut rates – this time to ZERO. If it worked before, why not again. I already pointed out one significant consideration, it worked after the Dot.com bubble because the general population HAD the capacity to borrow. Now they do not.
The initial rate cuts did nothing; banks weren’t lending to those that needed/wanted to borrow. The main reason is the general population had already been over extended, lost significant equity, and had no more room to borrow. Bank ratios were already extremely high and they too carried too much debt to lend.
The government and Fed had to move into unprecedented territory. They went further down the Keynesian Rabbit hole – going where no economist or nation has ever gone before.
One of the most shocking situations that needed to be addressed was the U.S. bond market. With rates at zero and the Western world in economic shock, the net buyers of U.S. bonds started to vanish. China, Japan, Saudi Arabia, and the rest of the huge buyers of U.S. bonds stop buying. One only had to ask the simple question to get the answer, who would buy bonds that paid zero? Answer = no one! The Fed, for the first time in U.S. history started printing money for the sole purpose of buying U.S. treasury bonds.
The U.S. government, who is operating on deficit spending (spending money it didn’t have and relied on the bond market to subsidize) was about to face collapse. Without the bonds, there would be no additional money for the U.S. government to operate – we were facing a massive shut-down. The Fed quickly became the largest purchaser (and now the largest owner) of U.S. bonds. The move was unprecedented and flew in the face of basic economics, logic, and reason. If you had asked any economic professor before 2008, “Could a government print money to buy its own bonds to sustain itself?” they would universally answer “No and any nation that tried would collapse.” The reason for their answer is simple, bonds are used to RAISE money for the government to spend. If a government prints money to buy its own bonds, it is circumventing the very nature of the bond market. Yet here we are and it “seems” to be working (for now).
Mortgage Back Securities (MBS)
If buying trillions of U.S. bonds was not enough, the Fed also bought trillions in failed Mortgage Back Securities (MBS). In another absurd move we shifted risk from the private sector to the public sector. Even though Freddie and Fannie (the largest mortgage companies collapsed and failed), the government bailed them out and nationalized them. They just took billions of bad loans off their books and put them on the Fed’s balance sheet. This allowed Freddie and Fannie to survive and now owned and operated by the government, they continue to issue more debt. The Fed now owns mortgages, again something that no one would even think possible or even consider. Any economist before 2008 would tell you that it would never happen, yet here we are.
Now with interest rates at zero, the Fed buying both bonds and mortgages, the next step was to inject trillions of new money into the system. The Fed increased the money supply in a huge effort to spur economic growth – more spending. Yet when measuring the velocity of money, it is not moving at all. It’s not moving, because it people don’t have the capacity to borrow – but the Keynesian economic theory does NOT consider this and thus continues to inject trillions into the market.
We need to ignore the political rhetoric. We can measure the real world economic problems and see them daily. In the heated political election circus both sides bring forth REAL issues that reflect our economic problem. Clinton talks about the wage gap and raising minimum wage. Trump talks about trade deficits and horrible trade deals. They both have a grasp of the symptoms of the economic problem, unfortunately neither has a real solution. Clinton wants to raise taxes and more stimulus (Keynesian Theory) and Trump, well I don’t think anyone really knows (for better or for worse).
I am not one that usually places blame, but I believe it is important to recognize the role of the Fed. Sure we can’t force anyone to borrow cheap money and take on massive leverage debt, but when it is encouraged and made available it certainly helps to exacerbate the problem.
I would argue, with reason and logic, that U.S. has created another bubble and this time bigger than the two that came before. It is an inflation bubble that is currently unmeasured.
First you have a Fed, which continues to purchase government bonds, mortgage back securities, increase the money supply, and keep rates close to zero. If the economy was so robust then why must they continue?The answer is simple, the economy has been at stall speed since 2008 and production continues to decline.
Second you have a Federal government that continues to stimulate and expand, rather than reducing its spending. Government debt continues to expand, regardless of who you wish to blame.
These two reasons alone: Fed monetary policy and government debt expansion (deficit spending) collective paint a bleak picture. Add in the consumers limited capacity to borrow more and growth is not going to happen.
To sum up my long post, the problem is much like that in Puerto Rico, there is NO PRODUCTION. If the consumers have no ability to borrow they can only consume at their earnings level. If wages are not growing, then consumption will not grow. To create jobs, increase wages, one most focus on production (Supply). Puerto Rico has a huge advantage over the states; it’s size, location, infrastructure, multi-lingual, tax benefits, and more. It also can’t “print” away their problems, so they MUST deal with them (unlike the U.S. Federal Government). Puerto Rico can, with effort and focus, become a small and powerful production force. That is why I am investing my time, money, and energy in Puerto Rico. The U.S. has a much larger and bigger problem and with the Fed, I don’t believe there is the current will power to do anything, since they can just print more money.
All the Fed’s Keynesian easy monetary policies will NOT create Production. We can print trillions more, take rates negative (like Japan), more stimulus programs, more bond buying, even buy stocks and corporate bonds – but without production the economy will not growth. The Fed’s policies are just buying time.
The U.S. is facing a serious dilemma and if Production does not become the chief focus and cause for the nation, then regardless of who becomes the President – the U.S. will face another economic crisis. I surmise we are too late and the next President will be facing an economic crisis of epic proportions.
Eight Year Cycle?
It took about 8 years to form the Dot.com bubble before it burst at the turn of the century. Eight years later a bigger bubble was formed that encompassed most Americans and imploded in 2008. Today we are approaching another 8-year anniversary and we have again created a massive bubble.
I am not one to believe in correlation is a proof of causation, but it is odd that after 8 years, President Clinton handed over the Dot.com Bubble to President Bush. After another 8 years, President Bush handed over the Housing Bubble to President Obama. Another 8 years has passed, who will President Obama hand over his bubble too?
Unless we change our thinking, our education, our understanding that we can never grow as a nation if we do not focus on Production, we are doomed to limp along on debt consumption until we can’t borrow anymore. We need people to understand that over consumption and endless debt will only end in economic chaos. Education is key, but are we too late? Maybe for this next bubble, but there is always a need for education regardless of what crisis we face. It is clear we did not learn from the dot.com bubble or the housing bubble.
It is the rise of the “entitlement generation” and new recent fascination with “socialism”, all of whom have been indoctrinated to believe in Keynesian economics (whether they know it or not). Every political ideology needs an economic engine, and for BIG government (be it Socialism, Collectivism, Communism, Statism, Welfare state, Corporate Welfare, Subsidies, Entitlements, etc) that economic engine is KEYNESIAN ECONOMICS. They believe one must spend and consume to grow an economy, without any care for production.
Education is vital, unfortunately the vast majority of universities in the West ONLY teach Keynesian Economic theory – as if it is the ONLY theory. What is shocking is MOST Economic Grads I have spoken with know NOTHING of Classic Economic Theory, Austrian Economics, Chicago/Fresh Water Economics, Adam Smith, John Locke, etc. For 4 years they are indoctrinated with ONE theory, the reason for that is our government and those of the West run on that theory alone. Why teach anything else, when the governments economic model is Keynesian? One would think our students should broaden their knowledge and hear differing views – but our Universities have become overly Politically Correct, with “safe zones”, “trigger warnings”, “micro-aggression”, all curtailing ones ability to broaden their knowledge. An Austrian Economist will never be welcomed at the vast majority of colleges in our nation, since their theories criticize and do not align with the government’s Keynesian Theory. We must change that if we hope for success. If even one person reads this post and decides to read up on the selected reading and viewing below and takes interest, then I have helped in some small way. Education is vital to shaping our future generation and to avoid repeating history.
It is this Keynesian belief system that is why we have ignored production and focused exclusively on spending. It is why the Federal Reserve continues down an insane path of self-destruction that could take the economy with it. Seriously think about it; negative rates, buying U.S. bonds, buying mortgages, buying stocks, buying corporate bonds – does anyone believe that it is a real solution, when and where will it end? It only buys time at the expense of our future.
Yellen’s quote, that instigated today’s preview concludes with: “…a more direct link to spending decisions.” She is telling us her focus is on one thing – SPENDING!
Courtesy of wikipedia
I am not sure how much longer and farther the Fed can go, whether it is negative interest rates or buying stocks and corporate bonds before it implodes, but it is the road we are heading down. We are coming up to the 8-year anniversary, just like the Dot.com bubble and Housing bubble. Is history really doomed to repeat itself?
Some Suggested Reading / Viewing:
“You can choose to ignore the math, but in the end you cannot avoid it!” – Michael Williams