Wednesday, May 1, 2013

When Ro-Ro Goes No-No

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession  (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

            A book finds favor when public opinion is willing to accept its proposition. This Time is Different: Eight Centuries of Financial Folly (2009) by Carmen Reinhart and Ken Rogoff funneled the debate of whether post-2008-crisis governments should increase spending ("fiscal stimulus") or cut it ("austerity"). The media's interpretative abilities further refined the on-off debate into a single interpretation of Rogoff and Reinhart's book. A country where public debt exceeds 90% of GDP is walking the gangplank. There is no shortage of such countries; the most heated debate has been in Europe. It is at emergency meetings among the world's acronyms where bureaucrats decide whether formerly sovereign nations are to be hexed with "austerity," or not.

            At the moment, there is a hiccup over the book's interpretation. That is not the topic here. The ruckus among noted economists concerns some re-regurgitation of the authors' data. Some new computer output aids the anti-austerity forces, who believe central bankers can eventually produce enough money on a keyboard to restore world prosperity. This accumulated phony wealth accompanied by asset-price targeting is the reason these institutional has-beens still control the public forum and weary us with recreational mathematics.

Outlined below is an interpretation that matters. The Summer 2012 edition of The International Economy published "Rethinking the Rogoff-Reinhoff Thesis," by economist Bernard Connolly, author of The Rotten Heart of Europe, and proprietor of Connolly Insight, his economic consulting firm in New York.

Connolly recognizes that the parties above (Rogoff, Reinhardt and all the categories of data interpreters mentioned) have mishandled This Time is Different. They have done so because the data has "not been set within a theoretical framework." The reason for such ignorance is "straightforward. The world, or at least the United States, became dynamically inefficient in the second half of the 1990s (perhaps for the first time since the 'roaring twenties'): the real interest rates tended to be less than the expected trend real growth rate. The culprits? Fed Chairman Alan Greenspan, European monetary union, the academic macroeconomics industry as a whole and its worse-than-useless DSGE models, and central banking theology as a whole with its dangerous inflation-targeting obsession. Over-financialization and excessive risk-taking by financial institutions were the consequence of this mess, not the cause."

Cutting to Connolly's point of illusory wealth, central bankers believe they can right any economic disturbance: the heart of their DSGE model. Why did Ben Bernanke claim sub-prime was "contained" in 2007 and wave off bubble concerns presented to him (February 2013) by the new bureaucracy he commissioned to warn him of bubbles? Because his dynamic stochastic equilibrium model is correct. It is always correct. He is the "A" student.

Except, it is wrong when the economy is dynamically inefficient, characteristics of which (see examples above) are exactly those being chased by central bankers today. Connolly quotes from "the magnificent, awe-inspiring Foundations of International Economics" (1996), written by Rogoff and Maurice Obstfeld: "The behavior of dynamically inefficient economies wreaks havoc with much of our intuition about the laws of economics." (Connolly explains the economic problems currently being exacerbated by official policy cause a reduction in future consumption possibilities, meaning, much of the capital formation is based "on excessively optimistic expectations of future demand." This is explained in his paper.)

Connolly corrects a possible misunderstanding of how the illusion of wealth will end: "It is very important, in thinking about the implications of the Reinhoff-Rogoff research, to realize that what deters new participants in a Ponzi scheme is not an accumulation of debt, but a destruction of wealth, or more accurately, a realization that the wealth supposedly backing debt is illusory.... [I]f the wealth of debtors is illusory, the wealth of creditors must also be illusory."

The illusory wealth will be extinguished. Capital formation based on excessively optimistic expectations of future demand will end where it started. This may happen quite fast. I tend to think Bill Fleckenstein, my co-author of Greenspan's Bubbles, is correct. Bill has written on his "Daily Rap," that, "in today's money printing world, as I have noted, problems don't matter until they do, as the discounting process essentially fails to function."("Daily Rap," April 3, 2013)

Current market prices are controlled, or, at least significantly altered, by central-bank interference. Investors who enjoy the latitude of investing or not investing, and choose to hold "risk assets" (discussion for another day) believe, or hope, that central banks will continue to boost prices. There is no question that boosting asset prices is the top goal of central banks today.

The "realization that the wealth supposedly backing debt is illusory" (paper currencies are a liability of the issuer) will end. Connolly writes: "traditional 'fundamentals' have now largely been transformed into one overarching 'fundamental': the assessment of solvency. As a result, markets are exhibiting binary behavior ('risk-on' and 'risk-off'.)"

This is another way of saying: "the discounting process essentially [is] fail[ing] to function." When ro-ro goes no-no, the currency of choice will be real money: gold and silver.

As it happens, Bill Fleckenstein quoted Paul Singer of Elliott Management (who has been quoted here before), in this afternoon's "Daily Rap":

"The world is on a seemingly one-way trip to monetary debasement as the catchall economic policy, and there is only one store of value and medium of exchange that has stood the test of time as 'real money': gold. We expect this dynamic to assert itself in a large way at some point. In the meantime, it is quite frustrating to watch the price of gold fall as the conditions that should cause it to appreciate seem more and more prevalent. Gold may not exactly be a 'safe haven' in the sense of an asset whose value is precisely known and stable. But it surely is an asset that, in a particular set of circumstances, becomes a unique and irreplaceable 'must-have.' In those circumstances (loss of confidence in governments and paper money), there are no substitutes, and the price of gold may reflect that characteristic at some point." ("Daily Rap" April 30, 2013)