E-piphany

As the strikes continue in the land of Bastiat and de Gournay (who is credited with the phrase laissez-faire, laissez-passer), American markets extended the “It Could Never Happen Here” rally.

The Physiocrats de Gournay, Quesnay, and Turgot believed that government’s function was to defend the rights of life, liberty, and property – this latter point famously became “the pursuit of happiness” in one particular document, which has led to much confusion through the years – and very little else. Bastiat, writing later and bridging traditions of the Physiocrats and the Austrian School, argued that the law can’t perform this basic function if it is also promoting socialist policies which tend to run counter to at least the last two of these elemental rights.

All of these guys were French.

In 2010, French truckers blocked highways today in an attempt to cut off fuel supplies from Paris, in support of the second week of refinery strikes and ahead of a full nationwide union strike tomorrow. This is all resulting from Monsieur Sarkozy’s plan to raise the official retirement age to mon dieu! 62 years old from 60.

It requires no great feat of imagination to contemplate what might happen in this country when (not if) the Social Security official retirement age is raised from 67 (which is what it is right now for taxpayers born after 1960) to 69 or 70. Now, this isn’t going to happen any time soon, because any proposal for intelligent discussion on the matter results in stories like this one, in which the Democratic incumbent is filleting the Republican challenger for suggesting that he would consider the economic merits of raising the retirement age to 70. The challenger, Bill Flores, blamed a headache for making him say such a rational thing.

So he needs an aspirin, which ironically is all that Medicare will be able to afford to buy him when he retires.

As I said, U.S. markets remain blissfully unconcerned about our own fiscal challenges, apparently because the riots so far have been limited to Tea Party members. Equities also remained blissfully unconcerned about the surprise decline in Industrial Production (-0.2% when +0.2% was expected), some of which was related to utilities but not all. Stocks rallied again, +0.7%, with the 10y Treasury rate down to 2.49% and a small drop in inflation markets. I sold all of my 5y and longer TIPS today, and will invest the proceeds in OSM, short-term TIPS, commodity indices (GSG, possibly DBB), and cash.

Citigroup reported profits of $2.17bln. That result was sort of helped by the $1.99bln in loan-loss reserves. With the reserves decline, they beat estimates by 2 cents; without it they would have missed by 4-5 cents. To be fair, part of that decline in reserves happened because they disposed impaired assets at better-than-expected prices (their Citi Holdings division lost $4.64bln on loans, but released $1.54bln in reserves), but of course the impaired assets that are disposed of early are likely to be the best-priced of those assets. I continue to be amazed that with the mortgage refinancing mess likely to shove huge amounts of mortgages back on banks’ books, loss reserves are shrinking rather than growing. How huge? Well, JP Morgan analysts estimate $55-$120bln, spread over the next 5 years (see story here). I guess that bank’s loss will be mortgage investors’ gains, but it makes me scratch my head further at valuations in that sector. But what do I know, I’m an inflation guy.

.

Since we seem to be moving inexorably towards QE2, I want to revise and extend my remarks on IOER. I have been writing that the payment of interest on reserves is a primary reason, probably the primary reason, that QE1 went almost entirely into excess reserves. As the chart below shows, the sudden appearance of excess reserves is pretty closely related to the appearance of IOER; banks may “have a blank check to create money,” as one Fed official put it recently, but they have chosen not to do so largely because they are being paid not to.

Blue line is excess reserves (left scale).

As I like to say in my talks, the money multiplier is broken but we know who broke it and we know how to fix it. Just lower the IOER, even make it a penalty rate, and the excess reserves will turn into money quite quickly.

Now, you can see from the chart that excess reserves are gradually slurping back into the system even with the IOER where it is. Unfortunately, M2 money growth at 3.3% over the last 52 weeks (about 5.4% pace over the last 26 weeks) just isn’t going to do the trick. Lower IOER and you won’t even need QE2, at least not yet.

So why are excess reserves balances declining at all? Well, there are really three ways to get excess reserves to turn into loans. Banks hold excess reserves because the opportunity cost, in terms of the risk-adjusted expected return on the loans they would otherwise make, is too low to make that a superior alternative to holding riskless cash. We can change that calculus in three ways:

1. Decrease the expected return on reserves. That is, cut the IOER or make it negative, as I have suggested.
2. Increase the risk-adjusted expected return on loans by letting banks charge what the market will bear in interest. While big companies are not seeking bank loans, mid-size companies are, and are having difficulty finding credit. The reason they are having trouble finding credit is that banks know if they charge the rate that is necessary for them to make the required return on equity, Senator Chuck Schumer (D, NY) will be calling them the next day to ask why they hate America so much. Actually, he will probably just call the NY Times and hold a press conference to lambaste management. So the bank prefers not to offer such a rate. It is important to remember that when banks are forced to decrease leverage, they require a much larger margin on each loan to reach the same return on equity.
3. Increase the risk-adjusted expected return on loans by improving credit quality. This will naturally happen over time, which is the reason reserves are slowly bleeding into the money supply. Note, though, that this is very pro-cyclical…if credit quality improves enough, the excess reserves will start gushing into the money supply, adding money in a spastic reinforcement to the upthrust of the natural cycle. You want inflation? That’s how you’ll get it.

I think that’s it. I favor the IOER approach because no one can control Chuck Schumer, because we don’t want to turn back the clock and force banks to increase leverage, and because we have no good way to forcibly improve credit quality unless we were to offer banks guarantees on certain lending (and that doesn’t seem like a good idea to me). If you have another idea, I’d like to hear it!

.

Tomorrow, in addition to another rotten Housing Starts number (Consensus: 580k from 598k),  we will be peppered throughout the day by speeches and remarks from the Fed’s Dudley (NY), Evans (Chicago), Lockhart (Atlanta), Fisher (Dallas, but speaking in NY at the NABE luncheon), Kocherlakota (Minn), Bernanke (Chairman), and Duke (Governor). Keep a scorecard handy; 6 opinions in favor of QE and 1 opinion against is what I would expect. Any worse than 5-2 and it might mean we ought to rethink how certain we are about QE coming at the November meeting. Frankly I expect to hear much more about how QE2 will be implemented than whether.