In the election of 1960, which Kennedy barely won, there was a cartoon of a scowling Nixon, with this caption:
“Would you buy a used car from this man?”
It was made into a mimeographed poster and posted everywhere. Because the race was so close, any single factor could be blamed for Nixon’s loss. That cartoon had its share of analysts who said it provided Kennedy with his margin of victory. That was as good a guess as any, and it had the advantage of being tied to a grass-roots phenomenon that seemed to come out of nowhere. It was democracy at work.
Ever since, we have heard the phrase popping up: “Would you buy a used car from . . . ?” It has become part of the rhetorical landscape. I am doing my best to keep this tradition alive.
The President is the man from whom the world buys Federal debt. He is the nation’s representative agent. It is his policies that are assumed to be capable of maintaining “the full faith and credit of the United States.”
Woe unto that President who sits in the Oval Office on the day that this faith is tested by the capital markets. Woe also to his party.
THE WEST WING
I don’t watch any TV drama except The West Wing. I think it’s in its final season. It is steadily losing ratings to American Idol. I shall not berate American Idol because all I know about that cultural phenomenon is that a stupendously untalented Asian singer got a recording contract after he was booted off the show. I say, good for him. He is in the tradition of Florence Foster Jenkins, whose extraordinary voice is remembered by few. This is only true of people who never heard her famous record. Once you have heard it, you will never forget it, short of Alzheimer’s — maybe.
Watching The West Wing lets me see which political issues are filtering down to the script writers, who in turn serve as funnels to the sorts of people who watch the show — not the people who watch American Idol. The issues that appear as main plots on the show are like early warning indicators of what the literate viewing public may pick up next. There was a show this year tied to the falling water level of the Colorado River. Another show was titled Hubbert’s Peak, referring to the consumption of oil and the possibility that energy prices will soar, breaking the economy, or worse.
The most recent show had President Bartlett, a Nobel Prize winner in economics, come face-to-face with his old nemesis, who shared the prize with him. Bartlett is about as mature about this as a junior high school student who tied for valedictorian.
The West Wing always has at least two subplots going on, sometimes three. They get wrapped up, but the main story line rarely gets settled definitively. It is just dropped — rather like the show’s Nielsen ratings.
In the main plot, if it was the main plot, Bartlett reluctantly sits down to speak with his old rival, whom he describes as someone who makes Milton Friedman look like a middle-of-the-roader. The economist is Japanese. He brings the President a friendly warning. The deficit is too large. He is speaking of the Federal deficit, not the trade deficit. He says that Japan may not continue to buy U.S. Treasury debt. Other Asian nations may also cease to buy.
Bartlett counters with a standard argument: they do not want their assets to decline. Refusing to buy T-bonds would lower the international value of the dollar, and hence lower the value of existing portfolios of Treasury debt.
They never get around to discussing central bank policy, but they do speak about government policy. Bartlett admits that his greatest regret about his two terms as President is the deficit: $300 billion a year since 2001.
The reality, of course, is much worse. The script writers actually low-balled the problem. Bartlett argues that the deficit would have been high, no matter who was President. His rival presses the point: there will come a day when Asians will no longer buy Treasury debt. There will be a day of reckoning.
In terms of the size of the show’s audience, this exchange of opinions on international credit is probably the most sophisticated one that most of these viewers have been exposed to. It did lay out the central issue: Asians are buying Treasury debt and thereby keeping U.S. interest rates lower than would be the case if they stopped buying. At some point, they will stop buying: private investors, central banks, and commercial banks. At that point, the Treasury will have to find replacement buyers. It is unlikely that the Treasury will be able to persuade new buyers of its debt to do so at the low rates that prevailed before Asians politely bowed out.
You have been reading about all this for years. You may not be aware of the fact that the vast majority of Americans know nothing about this. They are not aware of the relationship between U.S. government debt, mortgage interest rates, the economy, and Asian central banks. They do not spend time thinking about possible scenarios that might result if Asian central banks cease buying dollar-denominated debt, including Treasury debt. They assume that someone is taking care of this. But nobody is.
WHO’S IN CHARGE HERE?
At every level of discussion, something is confusing for the experts on the next level down. Recently, Alan Greenspan testified that he doesn’t understand why long-term rates have fallen.
The international economy is complex, the product of competing bids and competing dreams of billions of people. Reality is more complex than our minds can comprehend, but we do our best to make sense of it.
The reality of credit/debt is that the numbers are enormous, the systems are decreasingly understood, there is no final regulator, but there are multiple national regulators who are unable to determine the direction of the whole.
What Greenspan can do is to influence the direction of the world’s largest economy. Right now, the push is toward rising short-term interest rates. This “push” is in fact a reaction against the absence of monetary push. The Federal Reserve has been inflating the adjusted monetary base, year to year, at a 5% rate. In the last three months, there has been a lot of gyrating up and down. The recent push is up, but not at anything approaching double-digit rates.
Debt is more than Treasury debt. Credit is way, way more than Federal Reserve credit. The free market is replacing central banking as the primary determiner of money and credit. It’s not how much is produced by central bank policy that counts. It’s what is done with it that counts. The capital markets determine this. The day-to-day decisions of traders, coordinated only by the price system, determine the flow of funds. Nobody is in charge.
I assume that the free market will produce better results than a tenured committee of agents for a government-protected cartel of commercial banks. But the cartel and its agents can create illusionary interest rates and thereby produce booms and busts. They cannot prevent busts, but they always try.
THE WEB OF DEBT
In a March 1 posting by Eric Janszen of Trident Capital, the author pulls together a lot of material in a short essay. I had seen some of this material before, but there are some new things that I think deserve consideration.
He quotes from a book I have mentioned before, Peter Warburton’s Debt and Delusion (1999). It is out of print. I have written to Mr. Warburton to encourage him to bring it back in print in some form. So far, it remains out of print. Janszen quotes Warburton. This was written at least six years ago. It relates to derivatives, which are futures contracts tied mainly to the movement of interest rates. Companies try to hedge their portfolios against adverse movements of interest rates. Speculators offer to bear this uncertainty if they can make money by betting right. One party bets on rising rates; the other party bets on falling rates. Wrote Warburton in 1999:
There is an even more serious dimension to the meteoric rise in the use of financial derivatives; the implicit credit system that operates within it. Quite apart from the inherent gearing of futures and options, relative to trades in the underlying securities, it is possible to use unrealized gains in financial assets (including derivatives contracts) as collateral for future purchases.
In other words, it’s a process of pyramiding. One profitable trade leads to more trades. The profits of one trade become the security (margin requirement) for the next trade. The knee bone’s connected to the thigh bone.
The persistent upward trend in asset prices has amplified these unrealized gains and has enabled and encouraged the progressive doubling up of “long” positions, particularly in government bond futures. It is easy to envisage how the cumulative actions of a small minority of market participants over a number of years can mature into a significant underlying demand for bonds. While financial commentators are apt to attribute a falling US Treasury bond yield to a lowering of inflation expectations or a new credibility that the federal budget will be balanced, the true explanation may lie in progressive gearing.
So that’s who is buying the used deficit from this man! Derivatives traders.
But the government can’t spend promises to pay. It has to spend money put up by investors or by the Federal Reserve, which isn’t putting up much these days. So, what is happening is that those putting up the money are hedging against interest rate moves by entering into contracts. The derivative market provides what appears to be insurance against bad guesses.
The question is: How safe is the insurance that is provided by speculators on the other side of these trades? Here, Janszen quotes from Martin Mayer, a long-time FED watcher. I think this is as astute an observation on the whole process as any I have seen. Mayer calls it Mayer’s Third Law. I wish I knew the first two.
Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer’s Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain’t got want to get and speculate. The logic behind margin requirements in stock markets and capital requirements in banking also holds in the derivatives markets. Permitting highly leveraged institutions to hold private parties behind closed doors is the political version of selling volatility: the predictable likely gains will one day be overwhelmed by an equally predictable disastrous loss.
That will be the day of reckoning. That will be the day when the optimism of the Establishment holders of debt will be sorely tested.
Janszen comments on the irrational exuberance of the 1990s and the failure of the system to unwind in 2001. Unlike the 1920s, the banks did not participate in the boom directly. They participated indirectly.
But banks did not participate much in the 1990s stock market bubble, thanks largely to post-Great Depression government regulations that limit banks’ exposure to equities. Instead, to generate the profits denied them by regulations and regulators in other markets, today our nation’s banks carry the liability of several trillion dollars of replacement value for the modern version of the intertwined, non-transparent and highly leveraged bets of the 1920s, but in the bond markets via OTC derivatives, rather than in the equity markets.
The banks are regulated. The over-the-counter market for derivatives, heavily international, is not. So, the regulators can direct where the money won’t go, point A to point B, but they can’t direct where the money will go, and by what paths.
This is why the regulatory system will be sorely tested when, as Mayer so aptly puts it, them as got try to collect from them as ain’t got.
The derivatives market is a $140 trillion (or thereabouts) unregulated market for unsecured promises to pay. The commodity futures markets are not far behind, though regulated.
The entire modern economy is essentially a gigantic system of promises to pay.
I keep thinking of those famous words, “Your check is in the mail.”
I am asking you to do me a favor. My new book, an economic commentary on the Gospel of Luke (700 pages), is now posted online for free. I know that most of you won’t want to read a 700-page book. But I want to make sure that my books are on hard drives all over the place. If I drop dead and the site is taken down for any reason, I want to be sure that the book, even though unread, is widely dispersed. You can always e-mail it as a PDF file to someone. To download it, right-click on the address. Right-clicking pops up a list of options. Choose “Save Target As… ” Name the file “Gary North on Luke.”
March 5, 2005
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