Market Comment Q1 2013



“Oh Lord, give me chastity, but do not give it yet.” So said Saint Augustine, and, with respect to fiscal austerity, so said the U.S. Congress. Just after the New Year, a deal was reached to roll back scheduled tax increases and maintain current levels of government spending. Thus, the fragile economic recovery was sheltered from an immediate and dramatic decline in aggregate demand that might otherwise have occurred.1


In the longer-term, of course, to the extent it prolongs excessive deficits, the fiscal cliff deal is the exact opposite of what is required. But it is only another skirmish in the coming budget battle. In the battle over raising the debt ceiling in 2011, Congress created automatic spending cuts—sequesters—that were to have gone into effect this past January 2. The thinking seems to have been that rather than face indiscriminate cuts, some sort of dialogue and agreement would be reached to forge a reasoned consensus. But that did not happen.

Though initial fiscal cliff negotiations began with grander ambition—with proposals from both sides to address entitlement spending—the end result was scaled down by half or more, leaving the main battle yet to come. In mid-March, the newly-extended deadlines will expire and, at about the same time, the debt ceiling will once again require raising. So, it is relatively easy to forecast another round of high-stakes political brinksmanship. A stable consensus on economic policy is desirable yet elusive in these polarized times. In the absence of a national consensus on how to address the nation’s long-term budget problems, any negotiations involving it are necessarily volatile. As the ides of March approach, we should be prepared for untoward outcomes.


With all the turmoil, the breathless media coverage, the grandstanding and all the rest, it is easy to forget that the government doesn’t actually run the economy. Happily, the vast bulk of the economy is in private hands, where motivations are more transparent and the market provides the consensus.


Despite the global headwinds of debt deleveraging and fiscal austerity—which can be expected to endure for at least several more years—there has been economic progress. In the third quarter, U.S. GDP rose 3.1%. The rolling four quarter change—shown in the chart above—shows the U.S. economy has been growing about 2% the last few years. Though this rate is disappointing following a sharp recession, it is consistent with our thesis that financial crises are usually followed by years of sub-par growth. This is because time is required before debt can be reduced and consumer behavior can return to whatever the “new normal” is.


More than anything else, time is required to work off excessive debt. Encouragingly, the repair of household balance sheets, which were stretched leading into the last recession, is well under way. With help from lower interest rates and a higher savings rate, the debt burden on households has dropped significantly. As shown in the accompanying chart, the debt service ratio, which measures monthly debt payments as a percentage of disposable income, has already returned to pre-spree levels. The debt-to-income ratio, however, which does not benefit directly from lower interest rates, still has a ways to go.

Sluggish economic growth has been achieved without much help at all from the housing sector, which only now seems to be rising from its nadir. With any luck, this is about to change. New housing starts have picked up dramatically since the middle of last year, perhaps reflecting the stabilization in housing prices (shown in our chart last quarter).

Traditionally, housing leads the economy out of recessions, as falling interest rates boost affordability. This time, of course, was different as the housing collapse in some ways caused the recession. Still, the confidence that stable or rising prices instills in homeowners will go a long way towards supporting further economic growth.

In Europe, things are different. Recession in the Eurozone threatens the global recovery now underway in the United States and (apparently) in China. Sharp recessions in the peripheral countries have restrained growth at the core. Germany and France grew only 0.2% in the third quarter and, for France, this was a positive surprise! Offsetting the sluggish economy in Europe, however, is an easing in financial conditions. As a result of decisive action by the European Central Bank this summer, banks and countries are no longer on the brink of collapse, though much work remains to deliver the promised benefits of closer fiscal union.

Finding the right balance between righteous fiscal austerity and policy support for the fragile global economy is almost a perfect analog to St Augustine’s dilemma. It will almost certainly dominate the political debate for the rest of this year.


1 While this is the prevailing economic orthodoxy, not everyone agrees that cutting government spending would reduce aggregate demand or that the government should be involved in managing it in any case.



An episode in Goethe’s Faust involves Mephistopheles convincing the emperor to print vast quantities of paper money as a short-term fix for his country’s fiscal problems. The end, as for many of Faust’s bargains, is ruin.

The story finds echoes today in consternation about the long-term impact of “quantitative easing”—a technique currently being used by central banks around the world to keep interest rates low. Many fear that quantitative easing will lead to debasement of the currency, hyperinflation and ruin; and that Ben Bernanke is the modern day Faust.

Let’s briefly explore the rationale and risks of quantitative easing.

With interest rates near zero, Bernanke took a leaf from Japanese policymakers and, in 2008, began a policy of quantitative easing. Essentially, it meant that the Fed went beyond its usual policy of manipulating short-term interest rates and began purchasing long-term securities to reduce their yields.


Bernanke argues that the beneficial results include an improvement in the housing and automobile markets and a rise in the price of equities, both of which provide impetus to household and business spending.

As a result of these purchases, the Federal Reserve Bank has accumulated assets worth over $2.7 trillion, up from $800 billion in 2008, an unprecedented expansion of both the size of its balance sheet and its leverage ratio. Having purchased these securities either directly from the U.S. Treasury or from banks and securities dealers, the banking system holds large balances at the Fed in the form of “excess reserves”—money that has not yet been lent out. No one is quite sure whether these excess reserves are harmless, as Bernanke and others argue, or are some sort of ticking time bomb.


That is, if banks decide to lend these reserves to the marketplace in search of higher returns, the Fed might be hard-pressed to staunch the money supply expansion and potential inflation that would result.

Bernanke argues, credibly, that the Fed, though somewhat in uncharted territory, does retain adequate tools to control the money supply. First, it can raise rates the old-fashioned way, via the Fed funds rate. Second, it can offer to pay sufficiently high interest on excess reserves that banks will keep them on deposit rather than lend them out. And finally, it could sell its long-term holdings. In our view, these tools are sufficient ammunition for the Fed.

However, underlying the unease about the availability and efficacy of policy tools is a more fundamental concern: is a currency backed only by confidence, and not by gold, trustworthy in these uncertain times? After all, it has only been since 1972 that the entire world, for the first time in its history, has run on fiat currency.

The concerns are increasingly widespread. In the last presidential election, Ron Paul won a following by voicing serious doubt about the long-term viability of fiat money. The title of his book, End the Fed, was a campaign slogan. Alan Greenspan, the former Fed chief, also joined the chorus, saying that “fiat money has nowhere to go but gold.” Since the financial crisis began in 2007 the price of gold has doubled.


Jim Grant, of Grant’s Interest Rate Observer, put it well: “It is the nature of gold that its valuation must forever be a mystery. It earns nothing. It pays no dividend. No conference call, no management to call up and complain to. What I do think is gold is simply the reciprocal of the world’s faith in the institution of managed currencies. It is one divided by T, where T stands for trust.”

While we perceive the challenges to the current global monetary system, we take a more optimistic view. The current system of fiat currencies has the primary advantage of being flexible enough to contain a multiplicity of national agendas, which seems a necessity in a globalized world. In the Depression, the exigencies of adhering to the gold standard may well have exaggerated the economic downturn. The world may well return someday to some tighter currency regime, but a change does not have to be preceded by calamity.

Time will tell which direction the global monetary system will take. For the moment, there is very little chance of inflation or hyperinflation and plenty of focus and commitment on the part of central banks everywhere to forestall it. When the time comes for the monetary system to evolve—as has already been suggested by China and France and many others—it is perfectly capable of doing so in an orderly manner.


Science blogger Robert Krulwich posted this nighttime satellite photo of North America on his National Public Radio blog with the following comment:

“This is odd. Take a look at this map of America at night. As you’d expect, the cities are ablaze, the Great Lakes and the oceans dark, but if you look at the center, where the Eastern lights give way to the empty Western plains, there’s a mysterious clump of light there that makes me wonder.”


“What we have here is an immense and startlingly new oil and gas field—nighttime evidence of an oil boom created by a technology called fracking.”

Kulwich goes on to explain that the lights are from hundreds of drilling rigs in the Bakken formation, which underlies Montana, North Dakota and Saskatchewan. The formation, named for the farmer on whose land it was initially discovered, is estimated to contain 250-500 billion barrels of oil.

From a standing start six years ago, North Dakota now produces 660,000 barrels of oil per day. In the U.S., only Texas produces more. How much of this resource can be extracted—estimates range from as low as 1% to 50%—depends on both the price of oil and how good companies get at fracking.

Suffice it to say that whatever controversy is generated by fracking is bound to be large—and visible from outer space.


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