Click here to read this article in pdf format:Â July 23 2012
(republished from “A View from the Trenches” (www.sibileau.com)
We have not written for the past two weeks. We were vacationing but at the same time, nothing really changed a single dot of the macro picture. Perhaps the main development has been the collective (but still minimal) realization that markets are being manipulated either by governments or banks. The starting line, it seems, is the manipulation of the London Interbank Offered Rate (LIBOR). We are not going to add to this. We expressed our comments in our last letter. Those interested in following the issue can do so at Zerohedge.com.
The relative calm therefore affords us the opportunity to reflect upon a topic that has and continues to personally bother us, with respect to the comprehension of the ongoing crisis. We are referring to the circular reasoning behind every proposed solution to this crisis.
We remember affectionately the first time we were confronted with circular reasoning. It was courtesy of Antoine de Saint ExupÃ©ryâ€™s famous book, â€œThe Little Princeâ€. In its chapter 12, the Little Prince meets a tippler, a drunkard (original drawing from the author, above), and the dialogue goes like this:
â€œWhat are you doing there?â€ he said to the tippler, whom he found settled down in silence before a collection of empty bottles and also a collection of full bottles.
â€œI am drinking,â€ replied the tippler, with a lugubrious air.
â€œWhy are you drinking?â€ demanded the little prince.
â€œSo that I may forget,â€ replied the tippler.
â€œForget what?â€ inquired the little prince, who already was sorry for him.
â€œForget that I am ashamed,â€ the tippler confessed, hanging his head.
â€œAshamed of what?â€ insisted the little prince, who wanted to help him.
â€œAshamed of drinking!â€ The tippler brought his speech to an end, and shut himself up in an impregnable silence. And the little prince went away, puzzled.
â€œThe grown-ups are certainly very, very odd,â€ he said to himself, as he continued on his journey
Later in life, we also faced (but donâ€™t remember so affectionately) other circularities: The logics of the US immigration system (where one needs to have a visa to work, but needs to have a work offer to apply for a visa) or the beginnings of our career, when it was difficult to land our first job because we had no previous work experienceâ€¦
The most damaging of all circularities however, can be found in the policies undertaken by central banks, regulators and governments in general, worldwide. Where to begin? Since we are deductive, letâ€™s start at the core of the problem, which is the way macroeconomics is conceived by the establishment:
In the minds of those who lead the world (at central banks, finance ministries, regulatory agencies and business schools), markets, at one starting point, are in equilibrium. A shock (in todayâ€™s case, of a financial nature) shakes the status quo and it is commonly perceived that itâ€™s the governmentsâ€™ duty to restore equilibrium. The shock, of course, they think is exogenous: it came from outside the system, could not be forecast in advance, but can be prevented in the future, with more regulation.
The first mistake here is to believe in the existence of equilibrium. We will not say more about this (but there are entire books available on this topic). Humans are constantly acting, trading, and they do this based on price signals. Profit and loss therefore are essential features in the system, that tell us whether what we do is indeed of value to the market or not. As long as we leave profit and losses unrepressed to guide us, we will get as close to that elusive equilibrium as we can possibly get. Why?Â IfÂ we do something of value for the market, the market will tell us to do more of that: How? By making us profitable. If we donâ€™t, the market will tell us to stop and to rather allocate the resources we used, including our mental capital, to better uses. How? By making us unprofitable. If we insist with the wrong course, we will go bankrupt. Paraphrasing Gordon Gekko: Bankruptcy, for lack of a better word, is good for the system!
Having said this, we acknowledge, financial shocks are caused by market bubbles. All asset price bubbles were the deliberate (not coincidental) result of some sort of signal suppression, price suppression. All of them. But to begin with, the worst price suppression we have today is in the banking system, where loans, which are multiple times the actual value of deposits, are not marked to market, but carried on an accrual basis. The Euro zone is learning right now about the consequences of this, as their banks carry depreciating sovereign debt. The system there has fallen into the vicious circularity of governments guaranteeing or capitalizing these institutions that go bankrupt precisely because they are creditors of the same who provide the guarantees or equity injections.
But the story doesnâ€™t end here. Leaders conclude that the bubbles were caused not by the suppression of prices but by irrational behaviour. This idea has become so popular that during the 20thÂ century we have seen the birth of a new branch in economics: Behavioural Economics. The whole notion has become so ridiculous that in 2002, Dr. Daniel Kahneman received the Nobel Memorial Prize in Economics, despite being a research psychologist, for his work in Prospect theory! None of this would be really needed, if we understood that failures and losses are a good thing because in the â€œsystemâ€, they mend mistakes before they reach systemic proportions. The regulations proposed to mitigate irrational behaviour therefore do nothing but to exponentially increase systemic problems, exposing us to another circularity.
Take for instance the insistence imposed upon banks worldwide, that in times of stress, their creditors be converted to equity holders, to strengthen the capital structure of these institutions. This policy is also an exercise in circular reasoning: It leaves banks without access to credit (either senior or subordinated, unsecured or ultimately secured) and with worthless equity. The only ones holding the bag are depositors which, as in the Euro zone, end up demanding unconditional guarantees of their governments and even after getting these, they withdraw their monies (i.e.Spain). Therefore, governments end up trapped in the circularity of causing bank runs by their own policies.
There is another circularity, which is perhaps the least understood. The Fed and a myriad of other central banks have not only a mandate on inflation but also on maintaining a target level of activity, or employment. These central banks therefore focus on the so-called excess capacity of their respective currency zones to reach a decision on their benchmark interest rates.Â We will show that this is circular reasoning in hiding, because it makes no sense to think that a company that produces, say, 10,000 cars per month but has the capacity to be producing 15,000 should be producing those 15,000 cars per month. Â However, given the cost structure and prices the company gets for its produce, the optimal amount they choose to produce is 10,000. Period. Because if they produce more, they may incur into a loss and may even go bankrupt. Think about it in your own termsâ€¦At the given income you earnâ€¦would you work and additional half-time, for no other reason that if you â€œinvestâ€ in doing so, you will simply earn the same per hour of work or less? Clearly you wouldnâ€™t, unless your marginal salary rises. So, why would the rest of the world do so?
The key thing is then to ask: What set of relative prices were present back at the time when the company decided to invest to have a capacity to produce 15,000 cars per month? Who created those artificial relative prices? Could we not say that the 0% interest rate imposed by a central bank is one of those artificial prices? But if we are right, is it not clear that there is a circularity when a central bank sets a rate following data on capacity? After all, the additional unused capacity was driven by a low interest rate policy and encouraging the build up of more capacity only exacerbates the problem.
At the heart of all these circularities is the fact that the world has fiat currencies and the worldâ€™s reserve currency is used to support a Ponzi scheme, where the US Treasury gets into debt to repay the outstanding debt and its interest. Like all lies, this one will be exposed when the fact is confronted with the story. Today, the story is still winning over the fact, thanks to the existence of futures markets, through which commodity spot prices are manipulated (think oil, gold).
Why? Because, central planners believe in managing expectations. Remember, they think that markets act irrationally and if one can manage expectations, as in the case of inflation expectations, one can get away with printing money. They believe that the prices of commodities are one of the main drivers of inflation expectations and by maintaining these prices suppressed, people will not think the current policies will end up in high inflation.
How is this done? The existence of futures markets allows big players to set big naked shorts, which means that huge short positions, driving the spot prices down, are created without the seller actually owning the commodity. The underlying risk is obviously systemic, because once one of these sellers is exposed naked, theÂ house of cardsÂ clearinghouse falls. The futures markets are the Achilles tendon of this big house of cards we live in. As long as they exist, we will not see parabolic increases in the price of precious metals and once they cease to exist, capital controls will be overwhelming. Pick your poisonâ€¦
Mr. Sibileau currently works as Director for the Loan Portfolio Management team of a Toronto-headquartered financial institution. In his free time, he regularly writes on global macroeconomic developments at www.sibileau.com.
Since 1997, he has held various positions in the areas of corporate finance, strategy consulting, international banking, commercial banking and risk management.