The problem with "average returns"...

I have long disputed the axiom touted by our financial industry that long-haul equity investment would outperform other assets. Like too much advice it was a facile glossing-over of the actual impossibility of mortal individuals to experience long term average gains.

It turns out timing - spelled L-U-C-K - is a big factor as well. Those average returns are not the same for any particular investor lifetime.

One other scenario year is interesting just for the dramatic disconnect it shows. It involves those fortunate enough at the outset to have a pile of cash to invest. The period from 1975 to 2005 was a stunning three decades for the American stock market, returning 13.7 percent per year. A person who socked away $300,000 in the S&P 500 at the start of 1975 and reinvested all dividends walked away with $14.2 million in 2005.But the pattern of returns was distinctly unfavorable for someone who was a slow and steady saver throughout that period. Some of the years of the sharpest gains came early in that window, like the 38 percent return in 1975 and 24 percent in 1976. And then the last few years were weak, encompassing three straight years of sharp declines to start the 2000s.As a result, our person who invested $10,000 each year walked away with $1.59 million come retirement — nothing terrible, certainly; it was almost impossible to hold stocks during that 30 years without making money. But hardly $14 million.A final note. You can’t control any of this. We all happen to be born when we are born, and the future returns of the stock market are unknowable. As an investor, it is generally best to focus on the things you can control, like how much you save and whether you are putting money in investment vehicles with low fees that are tax efficient.But the luck of when you are born may have a bigger impact on how much you have for retirement than you might like. [More]

Again, I agree that average returns are a good source for basing decisions. Expecting average results is not rational, however. 

Now apply this principle to farmland. How do you think the returns on land bought in say, the last 5 years will match up to acres purchased in 2005, for example?

You drunken sailors... 

 I've already ranted about this, but if anything the Ag Meme of the Year is getting stronger.

"The year 2014 will be the sobering up period," said Michael Swanson, an economist and senior vice president with Wells Fargo, the largest private lender to U.S. agriculture. [More that will tick you off]

I wrote about the characterization of the last few years as a party in TP recently. In fact, I think I'll just save some time and repeat myself:

Party? What party?

It’s hard to turn a page in ag media without encountering a description of recent years as a party, which is now sternly declared “over”. The metaphor is inaccurate at best, and faintly insulting to farmers at worst.  There is scant evidence of either mindless revelry or foolish extravagance. 

This image of farmers squandering prosperity originates, I believe, with critics who remember 1973. Returning in ‘75 after a decade away I discovered fellow Boomers exhilarated by that still unrivaled income spike. We put our name on lists to buy a new tractor; men who seldom drove 150 miles to Chicago flew often to Las Vegas; we couldn’t buy big enough pickups. Goaded by government policies (10% investment tax credit), equally giddy lenders, and elders we delighted in defying, many did go overboard. 

But agriculture had just emerged from a grim economic period, and was still an occupation of exhaustive effort and financial naiveté. Children didn’t just leave the farm – they fled. The socioeconomic gulf between farm and city was wide. Young men urged off to college (like fathers drawn off to war) saw other lives and decided they knew what “better” looked like. Mostly it centered on living large. Returning home, they already had an idea of how to celebrate, and only needed the resources. In hindsight, the results were unsurprising.
During the Eighties, the survivors grew up. So when this current run of good fortune occurred, the response was markedly different, which is reflected in USDA financial reports. 

We have used prosperity to reinvest in our long-term future. When critics point to “outlandish” land prices, remember, regardless of price, land is an investment, not a consumable. We have installed tile, terraces, and pivots at an unprecedented pace. We have built homes and bins and buildings that will serve our grandchildren and beyond. We have paid down debt to historic ratios. The balance has been herded into long-term notes with rock-bottom fixed rates. These aren’t the actions of people at a particularly fun party. 

Unnecessary New Paint? Even this supposed failing is not without rationale: “Yeah, but we can go X years without buying another machine”. Farm machinery is correctly classified as a “durable”, and dealers fear demand has just been pulled forward. Our sheds are better seen as a well-stocked tool chest. We have also learned that even if we admit to being “over-machined”, the narrower fieldwork windows of our era of climate change often prove we have barely enough. 

Above all, after decades of laments, we took the earliest profits and finally, in the words of my father, “outbid the world” for our sons and daughters. We “bought” our best and brightest home. 

To be sure, our living standards (expenses) have increased. However, a 20% increase while net farm income was more than tripling does not strike me as disproportionate. Even the notable upswing in farmer leisure from golf to getaways is better seen as an overdue revision of an all-work-all-the-time ethic that only served to drive our children from the land, stress our marriages, and narrow our vision. Rural lifestyle rebalance and firsthand global experiences were valuable investments.

Perhaps the transition from lower-middle class to upper-middle class was simply easier than the abrupt change from lower to middle class in the ‘70’s. Or maybe 21^st century producers had already learned what money could not buy.

Nag, nag, nag. Meanwhile, we have been regularly harangued about our historic tendency for financial excesses. (We heard you, already.) Perversely, the only example of embarrassing indulgence that comes to mind involves one perennial haranguer: the Farm Credit System. (More soon) 

I have been a relentless – OK, tiresome - critic of our profession for our subsidy addiction and brazen boasting, but on this issue I am convinced it’s a bum rap. While we gratefully rejoiced to advance long–desired goals, producers managed this bonanza with remarkable self-discipline and forward thinking. 

So, regardless what happens to farm income, this party isn’t over. It never happened in the first place.

There are many possible strong rebuttals to this condescending characterization that are conveniently left out of media quotes:

• There was not party in the protein sector: from hogs to milk to chicken. In fact, the last few years have been multiple trips to heck and back.
• I think the financial community is pissed because we invested in farmland, where they couldn't get their hands on the wealth to churn and derive commissions. Once we bought land, that money was put of reach and they were holding a 30-year 4% mortgage which was the best they could charge. 
• Bankers have been prophesying interest doom for over a decade now. Swanson has to my sure knowledge, as I have followed him at conferences over that time period. Even by their self-serving standards they are starting to look a little foolish, even making Chicken Little a calm comparison. These aspersions to the character of agriculture are simply a way of diverting attention from their clueless doomsaying.
• The lending community truly does hold agriculture in contempt. While they tell us what we want to hear face-to-face, they tell Wall Street what irresponsible adolescents we really are.

If I banked with Wells Fargo, I would be sure to point out this derogatory description and customer disrespect and suggest it may be one reason why WF needed bailout money during the recession.

Farmers are quick to rail against anti-GMO or CAFO opponents. It's time we realized much of image problem could actually be generated by people like Swanson describing us as incompetent drunks, while claiming to be on our side.

Even Wall Street isn't forever...

All is not well among the Masters of the Universe, it seems. 

The article features lots and lots of boo-hooing about how hard they work and threats to move to Silicon Valley and be the next Zuckerberg. But this article makes the case that Wall Street itself is in a very serious retrenchment the likes of which have never been seen before. The insane compensation structure is over and the industry is facing the unpleasant task of figuring out how to make money legitimately again. Part of it stems from Dodd-Frank, which everyone knows was inadequate, but is potent enough to have made the banks change their structure in anticipation of the presumed effects. But the bigger factor is that it finally dawned on these guys that their model was unsustainable --- they were basically selling air. To each other. [More]

It has been hard for me as a free market enthusiast to understand the arithmetic of finance as well. I found it difficult to believe they made all that money by making the markets more efficient in allocating capital. Further I could not see the finance sector delivering so much value as to constitute the biggest sector in our economy.

While the regulation mentioned above is certainly a factor, I think the rise of black-box trading and the absence of the public to regularly fleece have been equally corrosive to extravagant profits. Moreover, the fees are being side-stepped by large investors in the wonderfully mysterious "dark pools".

So-called dark pools – off-exchange facilities that allow trading of large blocks of shares, with prices posted publicly only after trades are done – are perceived by many as offering an advantage over exchanges.Tensions between exchanges and brokers have escalated in recent years as trading outside public markets has crept up to record levels and put further strains on the once-dominant share trading institutions such as the New York Stock Exchange and Nasdaq.Rosenblatt Securities estimates that more than 37 per cent of all US stock trades are now executed at off-exchange venues run by brokers. Exchanges and some large investors argue that the increased trading away from the public markets has diminished the value of publicly quoted prices. [More]

In other words, eventually people leave inefficient markets. Just like farmers buying and selling farmland privately, who needs to pay 6% if you can reach an agreement on your own?

However, one ongoing premise in my view of what is happening in global finance is an excess of assets in relation to investment opportunities. Stocks are historically overvalued already in light of returns, but with bonds and other alternatives offering slim to negative income streams, where should excess capital go?

In fact, I am less bearish on farmland than most, simply because I think we could see the return of outside investors as farmers back away (or are pulled back by bankers). There is simply too much liquidity, too little growth, and growing desperation by investors to try to find work for their money.

One thing it seems they have learned is, after the fees, it won't earn much on Wall Street.

It's like beauty, apparently...  

I have posted before about the lack of "safe" assets for very conservative investment purposes. It's not getting any better.

The global pool of government bonds with triple A status from the three main rating agencies, the bedrock of the financial ­system, has shrunk more than 60 per cent since the financial crisis triggered a wave of downgrades across the advanced economies. The expulsion of the US, the UK and France from the “nine-As” club has led to the contraction in the stock of ­government bonds deemed the safest by Fitch, Moody’s and Standard & Poor’s, from almost $11tn at the start of 2007 to just $4tn now, according to Financial Times analysis.
The shrinkage, largely a result of US’s downgrade by S&P in August 2011, is part of a dramatic redrawing of the world credit ratings map, which is encouraging investment flows into emerging markets and forcing investors and financial regulators to rethink definitions of “safe” assets. [More]

What I wonder is if the ratings agencies aren't playing with fire here by thinking they have the power to label and render judgment on assets. If US debt is downgraded and people still flock to buy US treasuries, don't ratings agencies risk being seen as irrelevant?

More worrisome (for them) is if another metric, by another self-proclaimed referee catches on instead. Safe could be in they eye of the beholder and we change our rules to fit.

A time for every purpose...  

Except debt, apparently. Carl Zulauf, whose work on farm policy I admire, posted and interesting piece on farm prices and input costs and came to this conclusion:

 

Last, the lack of a trend in the ratio of crop prices to input prices adjusted for productivity suggests that a key risk management strategy is to pursue the highest level of input productivity while not incurring large debt. Thus, history suggests a good risk management strategy is to use the current period of farm prosperity to improve farm productivity without incurring debt. [Source]

This is a non-sequitor , IMHO. What has debt got to do with it?

If debt can generate returns above the cost of servicing it, why not use leverage to expand (land) or increase productivity (tile)?

The statement seems to say: since you never can tell what your profit level will be don't borrow money. But it falls apart when real history is applied. During the above chart were there ANY times when debt paid off big-time?

Answer: you betcha. Suppose you mortgaged everything down to your socks to buy land 5 years ago - before land and rents doubled, and at modest rates - say 6%. Not only would you be reaping whacking capital gains, your debt service would be even more manageable because returns to ownership (rents) have climbed as well. Not only that, but you could be refinancing it now for 3.5% or so and adding to your windfall.

What the chart shows me is it is impossible to know when and how much debt will payoff, but there are times it is not just appropriate but very lucrative. The fact you cannot predict when that occurs seems to freeze economists into inaction, but leaves farmers who follow their extremely conservative advice as roadkill for those buy/rent aggressively.

In fact, a good question to ask the economic community is "When do you use debt to expand/improve"? I suspect the answer will be when it is indisputably predictable that debt service will be done without any cash-flow problems. In fact, I'll bet some of these guys have never urged farmers to borrow and buy in their career. Oddly enough, that has been the best thing they could have possibly done when done at the right moments. I grant it requires luck, but it really, really works!

Ag economists as a rule are categorically terrified of debt. (I blame tenure) Those who follow their advice slavishly will have been rolled over by those who took a risk and were proven right. The reward flows to risk, not to prudence. And it seems to me that trend is accelerating and the same advice we've gotten my entire career is essentially unhelpful to those of competing in a zero-sum game.

What actually would be useful is a matrix of conditions that would indicate more favorable (but still non-zero) risk profiles that producers could use help identify those moments of opportunity. Something like:

1. The debt service margin (net rent minus payment) can withstand ax XX% margin decrease.
2. Does this debt require knock on capital expenses? (More machines for more land, etc.)
3. Does the debt generate efficiencies that lower costs by XX% of the amount required to service it? (e.g., new combine lowers labor costs and boosts timeliness for fall work)

When you are surrounded with examples of people who did just the opposite of what Zulauf is advocating - and won big-time - it's hard to take his analysis as anything other than an academic exercise.

Finally...  

I think I know what the buzz-phrase of our day means.

The sooner the market regulators figure this out, the better off investors will be. Until then, we have a Central Bank driven market (if not quite CB run economy, as Congress has abdicated their role). The hated phrase Risk Off/Risk On actually translates into “What will bankers do next? Here is my guess and here is my bet.”
As noted above, “if the flaw is systemic, it requires only a small twist of fate for the next incident to result in disaster.” That is what we have today. The combination of HFT/Algos and Central Bank intervention has turned the concept of fundamental investing into a quaint anachronism.
“Modern disaster prevention can and should be about stopping trouble before it strikes, not cleaning up afterward.” I suspect that one day, things like macroeconomic trends and earnings will matter much more than they do today. It is likely going to take a significant dislocation to get there. . . [More]

As alluded to in the Junkbox above, I will be exploring more of the myth challenging work about investing being done by economists. It seesm to be confirming my belief there aren't many attractive (safe, rewarding, understandable) places to put cash these days.

An economy of debt...  

I have been struggling to get my mind around the working of the shadow banking system. 

It's not easy for me.

The shadow banking system is the collection of financial entities, infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge funds, money market funds and structured investment vehicles. Investment banks may conduct much of their business in the shadow banking system (SBS), but they are not SBS institutions themselves.
The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions - but it has been common practice for investment banks to conduct many of their transactions in ways that don't show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors.^[1] For example, prior to the financial crisis, investment banks financed mortgages through off-balance sheet securitizations and hedged risk through off-balance sheet credit default swaps.^[1]
The volume of transactions in the shadow banking system grew dramatically after the year 2000. By late 2007 the size of the SBS in the U.S. exceeded $10 trillion. By late 2009 the United States SBS had shrunk to under $6 trillion due to increased regulation, changes in business practice, and pressure from investors who in some cases no longer wanted their funds to be used in the shadow banking system. Globally, a study of the 11 largest national shadow banking systems found that they totalled to $50,000bn in 2007, fell to $47,000bn in 2008 but by late 2011 had climbed to $51,000bn, just over its estimated size before the crisis. Overall, the world wide SBS totalled to about $60 trillion as of late 2011.  [More] 

These complex, interwoven financial contracts are essentially a function of debt of various kinds - mortgages, bonds, commercial paper, and other assorted and newly arrived instruments. As the shadow banking system grows relative the the regular banking system, (avoiding regulation and offering bigger profits) demand for debt grows.



The idea of demand for debt is exactly the opposite of what most of us are conditioned to expect. Our moralistic teachings from the Depression Generation has left us confused about how debt could have any redeeming aspects whatsoever.


But the effect of what happens in the SBS immediately is felt in the money supply which in turn impacts economic growth in a big way.

The blurring, or even absence, of the line between fiscal policy and monetary policy in the shadow banking system is often ignored.
It’s no longer enough to understand traditional monetary policy transmission mechanisms (money multipliers, federal funds rates, reserves); it is also necessary to understand how the shadow banking system (collateral supply, rehypothecation) affects monetary policy, and vice versa.
And this also seems like the source of the many challenges in working out how to regulate the sector.
Because one thing that’s clear from the note is that the shadow banking system represents a lot of money, and more specifically a lot of credit flowing through the economy. Regulating it won’t be as easy as saying bring it all on balance sheet or higher capital standards (though the latter is probably still a good thing).
How to define, for instance, the appropriate coordination between the central bank and fiscal policymakers when the outstanding Treasury stock affects monetary policy in this way? Or how to go about discovering the right balance between government readiness to respond (as it did in this case) vs the moral hazard it would bring?

… and summary from Credit Suisse:

Crucially, this chart and the shadow money perspective allows one to see that there has been
(1) a huge and necessary change in the composition of the effective money stock,
(2) a big reduction in the velocity of circulation of liquid collateral,
(3) a sharp reduction in the value of illiquid collateral (houses),
(4) an increase in the “haircuts” on illiquid collateral (higher LTV ratios), and
(5) a big increase in the precautionary demand for money by both firms and households.
The net result cannot be reasonably characterized as posing a major inflationary threat – at least until such time as financial system deleveraging is more complete, collateral values, especially house prices have recovered substantially, and overall private sector credit demand is growing strongly…
The public sector is still doing King Collateral’s work. How long it acts as Regent may be the central question for financial markets in the next decade.

[More]

This is pretty obscure I know. But when we argue about the size of our federal debt, it is a powerful complicating factor.  The SBS needs an immense supply of US Treasury securities, regardless of whether we think it is a good idea or not to run deficits. This is one reason why despite now-decade long predictions of interest rate increases, it hasn't happened, and doesn't appear likely in the near future.


In order for the massive financial sector which has grown to about 1/3 of our economy - and its outsized rewards to those employed there - to continue, a steady supply of debt/currency is needed to substantiate deals as acceptable collateral. 


Our financial system has evolved from supplying limited capital to enormous demand for investment loans, to chasing limited investment opportunities with wads of cleverly contrived debt-based capital.


I don't see - nor do any economists I read - any way to reverse this trend. The investments the world needs are to a significant degree public investments - infrastructure is a great example - and the political winds are blowing us away from those ideas. Absent massive government spending on roads, schools, locks and dams, etc. we only have industrial production to fund. That's not enough to absorb both public (like China) and private pools of capital.


As a result the financial sector makes money by betting on itself. This produces little other than big winners and losers, and frantic action, to my eye. To make it more complex, it will take us a long time, I think to grasp the idea of a world where free capital is plentiful and places to put it or not.


Strangely enough, we have been in a similar position before: the Middle Ages, after the Great Plague.
Demand had collapsed and the tiny number of nobles with money had nearly zero investment choices. This is one of the reasons they chose to plow money into their afterlife by building cathedrals - it was simply one thing to do with their accumulating wealth.


It is almost impossible for many of us to comprehend debt as an asset, but it has to be for the counterparty, by any accounting system. The stronger we make our guarantees for both public and private debt the more we enable the SBS to spin off derivatives of them to trade in various manners. Aided by new technologies that slice time into tiny segments to extract value, the possibilities seem nearly endless, but I can envision an upper bound to this profit source, as it simply becomes more common.


The demand for high-quality debt, however, may never abate. In other words, it may be a long time before interest rates reach anything like what many of us consider normal.  Bad news for savers and investors, good news for those who can deploy capital profitably.

This might help...  

Are you sick of hearing about the Greek crisis affecting corn/soy/banana prices and you realize you have no idea what the heck is going on except the hardworking Germans are being asked to bail out crummy, corrupt Greeks?

Felix Salmon, one of the best econobloggers in the world of finance deploys some rubber ducks to educate you.




The most interesting part for me was the statement that bondholders have agreed to a 50% haircut.  That's pretty harsh, but essential to a resolution. Like our mortgage mess here, there must be some liability for foolish lenders, IMHO.

Still coming inside...  

I had wondered if financial turmoil has slowed the flow of fund money into farmland, like it has with commodities, but maybe not. At least one large hedge fund manager is doubling down.

Diggle plans to transfer ownership of his farmland into a holding company, in which outside investors can hold shares, he said. Vulpes, which currently manages about $200 million, will own and operate the company. After buying farms in Uruguay and Illinois, as well as a kiwi-and-avocado orchard in New Zealand, he plans to pour money into Africa and eastern Europe as global food prices soar.
The value of farmland in the U.S. has probably gained 20 percent to 30 percent in the last two years, while Diggle’s investments in Uruguay may have risen 50 percent as sheep and cattle prices almost doubled in Latin America this year, he said.
Agriculture would be the “single most interest opportunity over the next 10 to 20 years,” Diggle said.
Vulpes favors investments in metals, energy and food, and “dislikes” government bonds, he said.
“Being long stuff in the ground is going to be a better place to be than holding pieces of paper,” Diggle said.
The firm’s Testudo Fund, which is heavily invested in precious metals and the mining industry, has gained 2.5 percent this year. The Russian Opportunities Fund has declined about 10 percent in the same period. [More]

Of course, this may not signify much, because hedge funds are little more than a way to extract bloated fees from extremely rich people.

Much has been made about hedge funds’ failure to keep up with the major stock market benchmarks this year. But 2011 is merely the latest disappointment in a string of misses that stretches back nine years, according to one analysis of the hedge fund industry.
Money invested in hedge funds since 2003 would have generated a return of 18% through November, according to data compiled by Hedge Fund Research. That puts it far behind the Standard & Poor’s 500-stock index, which has generated returns of 29% over that same period, once dividends are factored in, according to Simon Lack of SL Advisors. The hedge fund underperformance is even starker when placed next to a small basket of investment grade corporate bonds, as measured by the Dow Jones Corporate Bond Index. That benchmark has gained 77% since 2003.
Factor in hedge fund mangers’ customary 2% management fee and a 20% cut in profits, and the gap widens even more.
While disappointing, Mr. Lack says investors have no one but themselves to blame.
“The investors are all sophisticated wealthy institutions, not retail investors. So frankly, it’s a lot of sloppy analysis,” he said. [More]

Maybe the continuation of hedge fund money into farmland is a bad sign, no? If nothing else, those farms will likely push the boundaries of cash rents if for no other reason than to pay their exorbitant fees. Try as I might, I can't work up much sympathy for the investors, however, which maybe underscores the growing social rift between that sliver of the very wealthy and even those of us doing pretty darn well. Be honest - aren't you rooting a teensy bit for the conniving hedge fund managers? Didn't you experience some titillating schadenfreude  during the Madoff revelations?

Yeah - me too.

Regardless, I think it is fair to say it is really hard to find places to put money that will 1) still be there in 6 months, and 2) earn a positive return. 

You can run...  

But you can't hide. I'm talking about hot money looking for safe place to live - theme that shows up constantly in my posts, I now realize.

I would guess I'm not surprised because I am ~130% invested in farm land, which not only has been safe for the last few decades, but lucrative. But if you are not a land nut, choices for safe investment are not ample.

You’ll find the above on page 143 of the Credit Suisse 2012 Global Outlook, which we’ve stuck in the usual place.
It shows how the world’s outstanding stock of safe haven assets denominated in either dollars or euros has evolved, adjusted to account for the Fed’s purchases of US Treasuries and other assets in recent years as part of quantitative easing.
You can see just how impressive the decline has been since 2007, and we’d also note that if Credit Suisse had been feeling uncharitable, they would have been justified in excluding French sovereigns.
The chart helps explain much of what’s happening in global financial markets now, especially in Europe (not on its own, mind you — we said “helps” explain):
– Begin with the ongoing collateral crunch, and how the decline of safe assets is directly tied to the dramatic fall in the availability of high-quality collateral in European lending markets. So much of it is now encumbered via direct bilateral funding agreements or by sitting at the central bank drawing liquidity. [More]

While I kinda thought this was happening, the scale of the shrinkage was alarming.It also makes me wonder, what will have to happen to make stuff that was downgraded upgraded in the future? I suspect only significant time and good performance.

Morality and debt...  

There has been a robust debate in the econoblogs regarding the Eurozone crisis and how the economic strength of Germany does or does not grant them the moral "high ground".  I have noticed this is often how debtor/creditor arguments devolve - the virtues of the lender versus the vices of the borrower. Tyler Cowen does an excellent job of listing the facets of this debate, and sums up this way:

I believe that the Germans have approached this crisis with some bad economic theories, a lack of understanding of how government spending cuts can be self-defeating in the short run, and a good deal of more or less deliberate self-deception about its partners in the union, not to mention Germany’s own ability and willingness to act “fully European.”  I’m also not sure that Germany has a path out of this which leaves their own financial system intact.  You can rack up the moral and practical minus points there in considerable number.  That said, I see a lot of intellectuals dismissing the perspective outlined above, rather than figuring out why it makes so much sense to so many people, not just in Germany.  I think the financial elites in the periphery countries themselves actually see it quite clearly.

The result is significant misunderstandings about what can happen and will happen in the eurozone.  Germany cannot and will not drop its moral perspective, even if there is some theory — and yes theory is the right word here, because no one knows these broad guarantees will work — of how a broader and far more costly commitment can set things right.

In reading American discussions of the eurozone, I am frequently reminded of earlier discussions of the Soviet Union.  Most outsiders simply didn’t realize how little social capital was left in the system, though some of the Soviet insiders did.  Might the same be true of the eurozone?  I’m not calling these countries corrupt, rather there may be remarkably little cross-national cultural capital, and remarkably little deep public support for a costly EU bargain, so little that many German (and other) insiders know that no grand bargain can be sustained or even seriously attempted.

I believe we need to be exposed to this moral perspective, and this intellectual Turing test, as a bracing slap in the face, as a wake-up call, and I see our unwillingness to do anything with this perspective, other than summarily dismiss it as a kind of tragic juvenile moralizing, as a sign of our own decline, right here in the USofA.

But it's the same transaction, people!  How can lending be an act of moral superiority and the borrowers' actions be cast as morally suspect? If nothing else, hasn't the lender then engineered the "fall" of the borrower?

To be sure, the economic and cultural character of Germany resonates with the "work ethic" moral training remains a powerful part of Western societies: hard work, thrift, gratification delay, self-determination, etc. But I think we may be outgrowing those values or at least failing to modify them to present economic realities.

One of the most powerful of these new realities is the abundance of wealth. In the face of that surplus the choices for investors are not always an array of solid, high return productive assets, but a sorry collection of higher-risk, low yield instruments. I do not disallow the German culture its moral high ground connected to thrift and good choices, but I do wonder why they should not bear responsibility for their investment choices - both private and public. Why were they pouring money into Greek, Spanish, Irish debt to such a degree they could not suffer bad consequences? Aren't they guilty of bad investment strategy at least? Should not they bear the consequences of buying junk?

This is the dilemma of capital surplus countries and individuals. You will seldom find another place to park your money as "virtuous" as your own business, since they would likely be in capital excess, too.

Meanwhile, Ezra Klein reports from the financial front lines.

Over the course of dozens of interviews conducted in Berlin over the last few days, I've spoken to members of Angela Merkel's government, members of the opposition Social Democrats, industrialists, and bankers. No one has evinced even the slightest willingness to see the euro zone crack apart. But nor have they quite said they're willing to save it. Rather, they remain serenely confident that they will save it. But they don't have a surefire strategy. They have a bet. A big one.
That's really the key to understanding the German psychology on the euro. In America, we keep asking why they don't join with the European Central Bank to end the run on the European periphery. The answer is simple: they don't want to end the run on the European periphery. To them, the run on Italy and Greece and Portugal and Spain is a feature, not a bug. It's leverage, and they want to use it.
Look how much it has already gotten them. Greece, Portugal, Italy and Ireland are working their way through stringent deficit-reduction plans. The widely disliked governments of Greece and Italy, which proved unequal to the task of fiscal reform, have been toppled. There is a good chance that the euro zone might become what Germany has always wanted it to be: a fiscal union, in which the members meet their deficit targets and reform their labor markets. And none of this would have happened without the markets making their run at the European periphery.
So to understand the German position, look at it from their perspective: Why in the world would Germany let up the pressure now? When they're so close to amending the very treaty underlying the euro zone? When France has joined with them on a set of reforms? When the market is doing what the Germans never could?
I worry this makes the Germans sound like puppetmasters. They're not. Many of their intended reforms are very sensible. The flaws they point to in the euro zone are, indeed, deep, structural flaws in the euro zone. They do envision a future that includes sacrifice on their part: eurobonds that raise Germany's cost of borrowing and a bailout fund -- excuse me, a fiscal stabilization fund -- that they contribute heavily to.
So my concern isn't that the Germans are selfish and calculating. It's that, without quite realizing it, they have become reckless. They are trying to time the market, betting that they can, in essence, manage the run -- that they can do just enough to keep the pressure on without letting matters get totally out of hand. They are like a doctor who, faced with an unhealthy patient presenting signs of a heart attack, demands to see the patient lose weight before they will administer the life-saving treatment.
In almost all of their arguments, the Germans are right. The euro does need to be fixed. But first it needs to be saved. The Germans are betting that this is their opportunity to do both. If they're right, it will have been a remarkable play. If they're wrong, it will have been a disastrous one. [More]

It will be some time featuring very low rates before this curious economic puzzle gets solved. The idea of excess money struggling to get a return despite being the trophy of economically prudence and self-discipline will take some time getting used to. My guess is we are nearing that time as the last of the ~5 year investment instruments roll over into sub 1% territory. I'm seeing it at my bank, and now in Europe.

[Update: Rats! As soon as I labored through this post, Kevin Drum explains it much better. And with punctuation, spelling and charts. It's a must-read for those newly interested in the euro.]

Savers need borrowers just as much as the reverse. Meanwhile, the ag markets have a huge stake in this political turmoil as we obviously miss the extra money in the pits.

Wall Street detour...  

Say what you will about the OWS movement, the idea of "The 1%" has taken root. While many before had questioned how the finance sector added so much value it was entitled to oversize profits, some of our best economic minds are having trouble seeing this to be true as well. In the process of thinking this through some are discovering something farmers have instinctively, if not consciously, believed. (Note my emphasis below)

But the bigger idea, I guess, is that the “normal people” helped by Wall Street are the 1%, and that Wall Street has its “fingers on the scales in their favor”, and that if the scales are tipped towards the 1%, then that means the 99% are the losers. They’re the prey for Wall Street’s predators.
I don’t buy this analysis. I don’t believe that Wall Street is meaningfully improving the lives of the 1%, except insofar as Wall Streeters are the 1%. (Remember that financial professionals make up only 14% of the top 1%, and 18% of the top 0.1%. They’re a large chunk, but by no means the majority.)
In fact, I suspect that the top 1%, if anything, are responsible for a disproportionate share of Wall Street’s income. Wall Street isn’t picking the pockets of the 99% and giving the proceeds to the 1%: it’s picking the pockets of the 1% and giving the proceeds to itself. And Wall Street is taking a whole bunch of money from the 99%, too. But for the 86% of the top 1% who don’t work in finance, I really don’t believe for a minute that Wall Street is helping them out by giving them the hard-earned money of the 99%.
I also don’t believe in some halcyon era when Wall Street was “an economic helpmate” to the 99%. It has always been very good at extracting rents, and very bad at creating wealth for its clients.
Narrowly speaking it’s easy to see where Emerson’s speech is coming from: the housing bubble was certainly instrumental in allowing millions of Americans to live beyond their means. And yes, Wall Street was a necessary part of the machinery of the housing bubble. But of course the Americans who bought beyond their means did not “get to continue living like kings”; instead, they got foreclosure and eviction notices. And Wall Street wasn’t there to help them when that happened.
But I don’t believe that Wall Street has its fingers on any scale. There are wealthy families who have managed to preserve and grow their wealth over many centuries — Italy and Germany both have quite a few of them, the ultimate Black Swan that was World War II notwithstanding. Those families tend to have a lot of real property: income-producing land, if you’re growing things like grapes or trees, is an amazing long-term asset, since the main rents you’re extracting come directly from the Sun. By contrast, the rich families who hire Goldman Sachs to look after their money and end up invested in Global Alpha or pre-IPO Facebook shares tend to be much newer money. They made it quickly, and they’ll probably lose it quite quickly too — it could quite easily all be gone within two or three generations. [More]

Long before I even suspected what was going on in big banks, I resented their seemingly unnecessary fee extraction rackets. This from a 1996 Top Producer article:

Much has been said about the single-minded focus of farmers for land. Interestingly enough, we are not the only profession with such prejudices. I have noticed accountants and financial advisers, for instance, tend to favor money, especially cash or easily convertible assets. The reason is analogous - they “farm” these assets like we do land. If you make your living by moving others’ money from one form to another, seeing it tied up for centuries in land, which ends their involvement (and commissions) is not attractive.[More]

The global financial sector is not earning its pay, IMHO. "Efficient allocation of assets", my posterior! We have cash piling up in companies and banks while deflation remains an ominous threat in the developed world, for the fifth year running. Does that sound efficient to you?

What finance has done is perfected rent-seeking tactics for all those who prefer cash as an asset over all other things. In a totally unexpected development, the world is awash in such assets, as the growing global economy and technology /productivity have generated more available capital and simultaneously tempered demand for private investment. We have enormous wealth looking for somewhere to be.

I feel perversely lucky I have always been absolutely terrible at managing money, and piled my wealth into other forms instead. Moreover, debt is one really good method to countering to the One Percent, when you think about it.  Nobody embezzles a loan.


When the game is rigged against you, don't play. And while everyone should feel free to to mock and deride the loopy protestors in the Occupy movement, it should give you pause that there is some serious kernel of truth fueling this anger.

If you had any doubts...  

About the attitude of at least some financial traders, this should dispel them.

[Yeah - the posting is really slow, but I sliced my thumb open on some electrical tubing and my whole hand is useless. It will pick up after harvest and construction completion. Honest.]

It's not about interest rates...

Ryan Avent actually reads the reasons S & P downgraded US debt. Clearly it is not about spending.

But this interpretation is incomplete and misleading. As S&P’s announcement makes clear, the inadequacy of the deal was only one motivation. As important (to me, even more important) was the the reckless and divisive battle that preceded it: 

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy … [This] weakens the government’s ability to manage public finances … 

This is crucial. Sovereigns aren’t like companies. They can’t go bankrupt, and creditors can’t seize their assets. Their creditworthiness depends as much on their willingness as their ability to pay. As Felix Salmon presciently noted before the announcement was made, it’s not our ability to pay that’s in doubt: 

America’s ability to pay is neither here nor there: the problem is its willingness to pay. And there’s a serious constituency of powerful people in Congress who are perfectly willing and even eager to drive the US into default. The Tea Party is fully cognizant that it has been given a bazooka, and it’s just itching to pull the trigger. There’s no good reason to believe that won’t happen at some point. 

Absent the toxic politics that infected the debate, we could have hammered out a deal that stabilized the debt without squeezing the economy too much in the near term. After all, Britain, Germany and even Italy seem able to do so, and we have in the past, too.

Investors largely tuned out the debt-ceiling debate until its final days out of a belief based on long experience that for all the antics and rhetoric of the Tea Party, the people who actually run Capitol Hill would never compromise the country’s credit worthiness. After all, it was Mr Boehner who reminded his freshmen colleagues that on the debt ceiling they’d have to act like “adults.” [More]

Along the same lines, I find the most alarming aspect has to to be the idea that a vote could force those who disagree with the far right to change behavior. I mean, that's exactly what the TP won't do when it loses a legislative battle. More to the point, hardliners misunderstand how things happen here in the USA. We don't chafe under restrictions of the law, we, in the vast majority of cases, agree with (albeit grudgingly in some cases) the purpose and voluntarily comply. 

The IRS could never do enough audits to catch all the tax frauds if we did not have this buy-in by the electorate. Nor could cops stop the speeders. And this is also the fundamental reason we have clearly lost the war on drugs - people do not "feel" criminal enough when using marijuana.

There seems to be no room for gaining support for positions from those who disagree with the right. Instead the joy is in seeing how much a small minority can impose on others.

There is a common retort that this is how the ACA was "forced" on the US. But there is a crucial difference - it was actually approved by Congress and the President. (Interestingly, the vote wasn't a whole lot tighter than many other landmark legislative actions, such as the Bush Tax Cuts). The TP works by preventing approvals, which is not at all the same thing.

In fact, they have raised obstructionism to an art form. Even simple appointment approvals are used as hostages for pet peeves or projects. But gumming up the works is not governing, as we will discover every day. When the ship is headed for peril, not changing course is a bad option. The whole strategy is based on a reductio ad absurdum theory of government by critics who can't be bothered to learn how complex our economy and government has to be to deliver the lives we lead.

In Washington, it’s almost trite to say that the political system is broken. It’s been clear for some time that things really are different, that norms and procedures that once kept fractious congresses functioning have eroded with terrifying speed. If anything, S&P is, as usual, noticing the deterioration too late. But that doesn’t mean the deterioration is not real, or that it should be ignored. Too often, the pressure in Washington is from interest groups and activists and political consultants who are, perhaps without meaning to, pushing towards further dysfunction. Those of us in Washington who would like to see the government work have long wondered when the business community and other entities who need a functioning political system would begin exerting a countervailing force. Perhaps it begins now. If not, then this may be the first of many downgrades to come. [More]

It will be interesting to read the text behind the other downgrades that may be coming. My bet is they are rating our process, not our bonds.

Side Note: There is some confusion about the effect on GSE bonds like the Farm Credit System.

Two dots...

I would never had connected: the Trib and colonial farmland speculation.

At issue is language regarding the legal rights of creditors vis-à-vis debtors. The United States has long had a body of law regarding this issue. A few years ago, for instance, the real estate speculator Sam Zell bought the Chicago Tribune in a debt-leveraged buyout. The newspaper soon went broke, wiping out the employees’ stock ownership plan (ESOP). They sued under the fraudulent conveyance law, which says that if a creditor makes a loan without knowing how the debtor can pay in the normal course of business, the loan is assumed to have been made with the intent of foreclosing on property, and is deemed fraudulent.This law dates from colonial times, when British speculators eyed rich New York farmland. Their ploy was to extend loans to farmers, and then call in the loans when the farmer’s ability to pay was low, before the crop was harvested. This was indeed a liquidity problem – which financial opportunists turned into an asset grab. Some lenders, to be sure, created a genuine insolvency problem by making loans beyond the ability of the farmers to pay, and then would foreclose on their land. The colonies nullified such loans. Fraudulent conveyance laws have been kept on the books since the United States won its independence from Britain. [More]

The difference between illiquidity and insolvency will continue to be hotly debated as the Greek financial crisis proceeds. Farmers may have a hard time intuitively following this debate as with our asset prices soaring, solvency is not the first concern.

In general, as finance is scrutinized more intensely, I think due diligence of lenders will be stressed more. And as bailouts have proven politically damning (especially on the right), that well of relief may have gone dry.

Another angle to consider...

As we hurtle toward default: the role of ratings agencies like Moody, Fitch, et al.

The short run picture is more complicated. Avoiding default is presumably the main concern, but if that could be achieved by a Dem capitulation to demands for large spending cuts, so much the better. On the other hand, maintaining any kind of credibility requires a downgrade well before default actually takes place, and probably a series of downgrades as the deadline approaches. Even a single downgrade would throw financial markets into disarray (among other things, investors who are required to hold AAA assets would have to dump Treasuries and, presumably, buy the bonds of other governments). That in turn would place huge pressure on the Republicans. While the idea of “not raising the debt ceiling” polls pretty well, the reality of “destroying the US credit rating” probably won’t. [More]

This is the wrinkle that makes blither about "technical default" so misleading, methinks. The debt market is poorly understood and badly predicted in relatively placid times. Debauching the benchmark debt instrument could provoke little or horrifically concatenated reactions, as outlined above. It seems foolish to find out which for very little gain.


We forget that too many internal investment rules, or mandatory legal guidelines use US Treasuries as THE standard of prudence. Moreover, the knock-on effect would ripple through all other "safe" investments which are actually backed by US bonds.


Where will nervous money go?

The center cannot hold...

Things do fall apart. And it would appear there are worrisome signs for the fabled American middle class.

But the reality may be even more chilling: Perhaps U.S. business is learning to get by just fine, thank you, without middle-class U.S. consumers. And while that may be good news for chief executives and shareholders, it could be the beginning of a new and socially wrenching political logic that leaves the great American middle behind.Wall Street, which is paid for smarts, not sentiment, has this figured out. In a newspaper interview this month, Robert C. Doll, chief equity strategist at BlackRock, the largest money manager in the world, pointed out that the fortunes of U.S. companies and the fortunes of the country as a whole were diverging: “The U.S. stock market and the U.S. economy are increasingly different animals.”Mr. Doll’s explanation for the shift was the increasing importance of international markets rather than the domestic one — of the rising middle class in emerging markets, rather than the stagnating one back home. He said that over the next five years, 70 percent of the incremental earnings of S.&P. 500 companies would come from outside the United States.Among the most high-ranking executives, capitalizing on that shift has become standard operating practice. Speaking this week in Washington at an Ernst & Young conference on emerging markets (disclosure note: I moderated some sessions), Steve Taylor, a senior executive at the energy and water company Nalco, explained, “In most cases, it is dismantling something you have in mature markets to build in emerging markets. So you have to take that step. It is very painful, but you have to take that step.”The move to consumers from emerging markets is just part of the story. Within the United States, the advertising agencies on Madison Avenue are discovering that the age of the American mass consumer may be drawing to an end. Instead, a new white paper by Ad Age, the industry’s trade journal, argues that growing income inequality means the only buyers who count are those at the top.“Simply put, as the discrepancy between the rich and poor has become more and more stark, a small plutocracy of wealthy elites drives a larger and larger share of total consumer spending,” the paper concludes, citing research that shows the top 10 percent of U.S. households account for nearly 50 percent of all consumer spending. “It appears that mass affluence may be a thing of the past — and that luxury marketers should reconsider how their products appeal to elite consumers.” [More]

Unlike some observers, I think it is possible for the US to continue to divert economic returns to a few for some time.  Of course, I think this is a really, really bad idea, but the forces I see assembled in Congress and boardrooms are formidable.

The tipping point might come when and if we move beyond a consumer economy and technology wrings the last few suckers' games out of the financial sector (when all the player are equally fast and savvy and governments have little to throw into the pot).

Currently the finance sector contributes about 8% of our GDP. I have a hard time seeing how they provide that much value, and believe the essential smoke-and-mirrors aspect of the industry will not endure forever. With fewer newbies to fleece (since the folks with growing incomes won't be in the US and will be "protected" by restrictive governments), and tapped out public sectors, profits will have to be made from commerce with entities like themselves: large financial firms. I think those will tend to be low margin stalemated outcomes.

Meanwhile, the vastly depleted ranks of the middle class will not be able to provide the steady tide to support the economic froth of the ephemeral finance industry. It may take some time, but making money by sleight of hand will not prove, I think, a permanent part of our economy.