VOL 1/14, DECEMBER 2010

IN THIS EDITION

•A CENTURY OF MONEY MISCHIEF: The US Fed recently celebrated the centennial of its founding at a historic hotel on Jekyll Island, off the cost of Georgia, where a secret meeting took place to lay the political foundations for what would become the Federal Reserve System. But what, exactly, does the Fed have to celebrate, as it was created, ostensibly, to promote financial stability?

•THE RISING SEA OF DEBT: As yet another wave of crisis rolls across the global financial markets, it is instructive to step back and look at the entire sea of debt. As is postulated by global warming theory, rising temperatures result in rising sea levels. Well, as the global debt crisis heats up and the sea of debt rises, it eventually yet suddenly swamps those living close to the shore. Whether a home is lost to foreclosure, a factory to corporate bankruptcy, or both are lost to the sea, makes little difference to the holders of the debt that is defaulted on. From an investor’s point of view, there is simply too much credit risk in the sea and they want it reduced. At first, politicians presumed this could be summarily accomplished with sovereign bailouts. But now the sovereigns themselves, one by one like dominoes, are toppling over. The credit risk, sovereign and all, must be reduced. This can occur either through default or currency devaluation. With few exceptions, policymakers appear to prefer the latter.

A CENTURY OF MONEY MISCHIEF

On precisely the same weekend in November as the Republican victory parties in and around Washington, the Fed celebrated its centennial far away from its DC home at Jekyll Island, Georgia. One-hundred years ago, seven US Congressmen and bankers gathered together in secret at this highly remote location to lay the political foundations for what would become, in 1913, the Federal Reserve Act.[2] The ostensible purpose of creating the Federal Reserve was to provide for greater financial stability in the wake of the US banking panic of 1907. So how has the Fed fared in this role?

Well the Fed has come a long way in its first hundred years, to be sure. Let’s consider for a moment this summary of the first eighty of those, by quoting G. Edward Griffin, historian and author of The Creature from Jekyll Island:

Since it was created in 1913 the Federal Reserve System has presided over the crashes of 1921 and 1929, the Great Depression of 1929-39, recessions in the years 1953, 1957, 1969, 1975 and 1981, and a stock market Black Monday in 1987. We all know that corporate debt is soaring, personal debt is greater than ever before, both business and personal bankruptcies are at an all-time high, banks and savings and loan associations have failed in greater numbers than ever before in our history, interest on the national debt now consumes half of all of our tax dollars, heavy industry has all but been replaced by overseas competition, we’re facing an international trade deficit for the first time in our history, 75% of downtown Los Angeles and other metropolitan areas are now owned by foreigners and over half of the nation now officially is in a state of recession.

That is the report card for the Federal Reserve after eighty years of stabilizing our economy. I don’t even think it’s controversial to say that it has failed to meet its stated objectives. The only controversial part is, why has it failed?[3]

Why indeed? There are, of course, two possibilities: Either the Fed is incompetent or, alternatively, it has a set of objectives other than those explicitly mentioned in the Federal Reserve Act. Rather than speculate on which of these two is correct here, let’s quote Mr Griffin again, this time regarding his understanding of the bail-out practice known as “Too Big to Fail”:

Every time one of the big banks gets into trouble, not the small banks remember, they’re the competition, the big banks get into trouble and they are bailed out at taxpayers’ expense. Always in the name of protecting the people... The bank goes to Congress and says “you know, you’d better do something about this because if we have to write that loan off our books we may be bankrupt, we could fold. And look at all of the depositors, good Americans, who have their accounts with us who would lose their deposit. Maybe the FDIC won’t be able to cover; we could have a crisis on our hands. If our bank fails maybe the other banks will fail too and we’ll have a national recession. Look how the people will suffer.” So Congress dutifully steps forward–remember it’s a partner in this–and votes the funds to guarantee the loans or in some way to pass the payments on directly or indirectly in some very ingenious methods to the taxpayer.

And let’s not forget that the Federal Reserve has not done a particularly good job at protecting the purchasing power of the dollar through the years. Once again we quote Mr Griffin:

[W]e’ve had a known inflation of 1,000% since the Federal Reserve System was created. Another way of phrasing that is that a dollar in 1913 buys about nine cents worth of goods. That’s how much money has been taken from us, taxed from us, through this hidden process.

I say 1,000% inflation that is known because it's much more than that. Have you ever wondered, as I used to, why don't we have more inflation than we have had? I knew they were creating this money like crazy, why only this inflation? And then I found out. Have you ever heard the expression that we're "exporting our inflation." Every once in a while you find that phrase in the financial section of the newspaper. It used to drive me crazy--how can you export inflation? It's one of those phrases that people use and I'm not sure most of the people who use the phrases know what they mean. Like the other day I read that the Federal Reserve System bought dollars today to bolster up the dollar. How can you buy dollars? What do you buy it with? They buy it with other currencies, the Federal Reserve holds a lot of different currencies, yens and marks and that kind of thing so they just swap currencies around.

This expression of exporting inflation--what does that mean? It means 70% of the American currency that has been created by our Federal Reserve System is no longer in America, it's overseas. Other nations use American dollars as their unofficial money supply. Especially those countries which have no realistic money of their own. These countries that undergo inflation rates of 5,000 and 10,000% a year, you can't work with money like that. Women have to take wheelbarrows full of paper money to the grocery store to buy a bottle of milk. You can't carry on any serious economic transaction with money like that and they don't, they use American dollars.

All the banks in those systems have dual types of money. American dollars are the mainstay of economic transactions in most of those countries. That's where a lot of our money went. We have been spared the inflationary impact of all that money because had it stayed here, it would've bid against the existing money here and would have diluted our pot even more and we would've known what the inflation should've been.

What happens when the day comes when for whatever reason these countries can no longer, or no longer wish to, use American dollars? What are they going to do with those dollars? They'll send them back. They'll buy something with them while they can. It'll be a big rush. It'll be our refrigerators, our automobiles, our real estate, our high-rise buildings, our corporate stock, our politicians, whatever's for sale. All of this money will come in and then we'll find out in a very short period of time what the true inflation rate really should have been all of these years.

Those words were spoken by Mr Griffin some twenty years ago. They are even more relevant today, following the Fed’s disastrous, serial bubble blowing activities of the past two decades, the colossal buildup of global economic imbalances, the exponential growth of the money supply and the federal debt, the monumental moral hazard of bank bailouts and most recently, the beginning of the next round of Fed balance sheet expansion known as QE2.

For those sceptical of Mr Griffin’s view presented above, that the structure of the Federal Reserve System was designed primarily to protect the large banks rather than to safeguard the purchasing power of the dollar, please consider the Federal Open Market Committee (FOMC) voting structure: Whereas each member of the Board of Governors in Washington and the President of the New York Fed always have a vote, only four of the regional presidents may also vote at any one time, on a rotation basis. This implies that, even in the event that all four voting regional presidents dissent from a vote, the Board of Governors in DC and the NY Fed President will nevertheless carry a 2:1 majority! In other words, the power resides clearly at the political centre, not the periphery. And historically, dissenting votes have come overwhelmingly from the periphery.[4]

Well, we’re quite certain the Fed enjoyed its party on Jekyll Island. But as the champagne was popping and a jeroboam was smashed against the hull, the QE2 was leaving the dock. There is no reason to believe that this particular Fed policy voyage will be any less calamitous than those that have come before. Have a check around now for life-vests and boats, they may be in short supply before long.

***

THE RISING SEA OF DEBT

Although we are somewhat agnostic with respect to the theory of global warming, we nevertheless find it a useful metaphor for understanding what is happening at present in financial markets. Imagine an apparently safe, productive city with many factories belching “debt” from their smokestacks. This debt subsequently “rains” down into the seas, which represent the credit risk of that debt. But some of the debt remains unseen, high up in the atmosphere, where it holds in the heat, contributing to a dangerously rising sea of debt, which one day, suddenly swamps the city. What appeared to be safe, productive and sustainable is shown to have been a mirage.

Now of course astute observers might have noticed years in advance that the sea was rising. Some of them might have tried to warn the owners of the factories that they were creating too much debt. Yet the owners were earning attractive profits and the management big bonuses. If any one of them were to have scaled back operations, then the others would have taken up the slack, pocketing those same profits and bonuses for themselves. No, these short-sighted owners and managers, blinded by greed, kept producing more and more of that debt until, one day, when the levees broke, they discovered the folly of their ways.

For many, “Market Failure” is blamed, in whole or in part, for the great financial crisis of 2008, which stubbornly refuses to go away. Yet we completely disagree with this line of thinking. Indeed, the truth is the exact opposite. We call it “Regulatory Failure”. Now what do we mean by that? Well consider our global warming metaphor above: What if the factories in question were being subsidised with artificially low interest rates? How about also direct government subsidies of various kinds, such as housing benefit for employees? Finally, what if a major factory, following years of poor risk management, had been bailed out some years before, rather than been allowed to fail? Naturally, given the above subsidies and also the implied bail-out in the event of calamity, factory owners would be less than concerned about the rising sea of debt. As for investors, no doubt they might have wanted a higher yield on the factories’ debt, but as long as they were confident that, as in the past, a factory in danger of default would be bailed out, they accepted lower yields. In our metaphor, the unseen debt that remains in the atmosphere represents the excess debt issued as a result of these various subsidies and moral hazards, which are the ultimate cause of the dangerously rising sea of debt, rather than the “forces of nature”, that is, the free and unregulated market.[5]

***

Once the debt levees break, investors are forced to react. In a panic, they seek to reduce credit risk. The most obvious way investors go about reducing credit risk is to sell assets. Obviously, if everyone tries to sell at once, this forces prices sharply lower and, if such securities are used as collateral in the interbank lending market, this can wipe out a substantial amount of bank capital and, in an extreme case such as fall 2008, threaten to bring down the entire system.

If regulators get in the way of panic selling, however, say by limiting price movements or removing price discovery from the market, then investors will naturally begin to seek ways to hedge their exposure by selling other assets that are correlated in some way to the distressed assets. This can quickly result in these other assets also becoming subject to panic selling, causing the same problem elsewhere. Yes, the government and central bank may try to build new levees or otherwise divert the flow of risk for a time, but as King Canute demonstrated, you can decree all you like but you can’t force the sea to recede.

As financial contagion spreads unpredictably like a flood around hastily improvised defences, regulators get increasingly desperate. Once things get to the point that the entire financial system is in danger, the urge becomes overwhelming to just step up and outright guarantee whatever credit risk is causing the problem. In 2008, for example, the Federal Reserve guaranteed a pool of highly illiquid, toxic mortgage debt that had contributed to the demise of Bear Stearns. Following the Lehman Brothers bankruptcy later that year, the Troubled Asset Relief Program, or TARP, was created to allow essentially any bank holding a dangerous amount of toxic or illiquid debt to receive guaranteed funding from the US Treasury. Eventually, the liabilities of Fannie Mae and Freddie Mac were eventually assumed by the Treasury in a conservatorship.

Other countries also took aggressive measures. In the UK, for example, nearly all major commercial banks were at risk of failure as a result of a general contagion effect and so the government injected a huge amount of equity, which it mostly retains to this day. Notable here is that the UK in fact followed the lead taken by Ireland some weeks earlier, when it provided a blanket government guarantee for all bank liabilities.

Now, such action can slow contagion, to be sure, but can it stop it? As the sovereign steps in to provide ever more explicit guarantees for the financial system, this places the sovereign in the front line, facing investors who may still desire to reduce credit risk. Just because credit risk has been assumed by the sovereign does not in any way imply that the risk has disappeared; rather, it has merely changed form, from private to public. Debt which investors previously thought would be serviced via private sector economic activity, such as the generation of corporate cash flows to service corporate debt, or the generation of household incomes to service household debt, now must be serviced by the government, which implies that it must be paid for out of future tax revenue.

Now think about this for a minute. Previously debt was originated, priced and traded in the marketplace based on estimations of how much risk was involved in a given private enterprise’s or household’s ability to service that debt. Following the implementation of a sovereign guarantee for the banks, the assumed debt is now going to be priced and traded based on estimates of the future tax revenue that can be devoted to debt service. This is where it gets interesting: What if a country already has a large debt burden to service? What if that country is also growing weakly or perhaps falling into a nasty recession? What if that country is increasingly politically unstable, with a coalition government that has just been brought down by a minority party withdrawing its support? How comfortable will investors be with this? Will they believe that their credit risks have declined materially? Or will they choose to keep on selling?

Well, we have just described Ireland and why investors are continuing to reduce their exposure to Irish credit risk. Recall that, in 2008, the government assumed the debts of the financial system in an attempt to stop an incipient bank run and restore confidence. This worked for a time, but with the country growing weakly, the sovereign debt burden has been growing exponentially to the point where it looks highly unlikely that that debt can ever be paid back at face value. Therefore, investors are understandably still trying to reduce their Irish credit risk by dumping the debt. However, this debt is held as capital by European banks, which will realise huge losses unless the value of the debt recovers. So, European policymakers have got into action to “offer” Ireland a huge loan–which they call a “bailout”–which will probably take decades to pay back, consigning the Irish economy to a generation of high interest payments, higher taxes, a reduced potential growth rate and, quite probably, a lower standard of living.

But wait a minute! Recent polls show that the Irish don’t WANT this “bailout”. They would PREFER TO DEFAULT. Just as a homeowner can make a perfectly rational economic decision to walk away from a mortgage which exceeds the value of their home, so the Irish can make a perfectly rational decision that, rather than spending the rest of their and their children’s lives servicing a colossal debt, they can JUST SAY “NO!” by defaulting, walking away and starting over.

The doomsayers respond to this by pointing out that the Irish government will find it difficult to access the debt markets again following a default and would do so only at far higher borrowing costs. Yes, that’s right, but ISN’T THAT THE POINT!? Just as the Irish may not want to eternally service a debt that was foolishly run up by well-compensated bank executives, they don’t want their government to ever have the option of assuming such a grotesque amount of debt ever again. “What’s that you say Mr Politician? Can’t access the capital markets to save a failing bank? OK, let ‘em fail. Can’t raise debt to pay for bloated, unsustainable welfare programmes? OK, end the programmes. Can’t finance some pet project in a representative’s district to help him get re-elected? Cancel it. Now let’s move on and get back to the business of working for a living, providing for our families and paying a reasonable, modest amount in taxes for essential services as we go along, rather than piss our hard-earned incomes away on debt that we can’t realistically service; on mismanaged private enterprises that have gone bankrupt; on welfare programmes that we can’t afford; and on political pork that serves no purpose other than to keep incompetent, corrupt politicians in power. Oh and by the way, we Irish fully understand that what we owe in debt, we owe largely to the English, who occupied our country for centuries, occasionally with brute military force. Well take this John Bull: WE DEFAULT!”

***

Of course, although Ireland, Greece, Portugal and some other countries in comparable circumstances might choose to default on their debts, in other countries, default is relatively less likely. This is especially true of those countries that can print the money required to service their sovereign debts. Sure, it might result in a devalued currency and inflation, but then doesn’t that in fact achieve what investors set out to do in the first place, when they decided they wanted to reduce their credit risk? The more a debt is devalued in real terms, that is, through devaluation and inflation, the more the credit risk declines, as it becomes easier to service that debt. In this regard, isn’t it convenient that the Fed’s recently adopted QE2 programme requires the Fed to purchase almost exactly the amount of planned US Treasury issuance during the coming six months? As markets anticipated the policy, the dollar declined sharply in value. Now with the euro-area in crisis and a potential war brewing in the Koreas, the dollar is suddenly much stronger. Well, guess what: This makes US Treasury debt more difficult to service. The Fed is not going to welcome this one bit. But if at first you don’t succeed in devaluing your currency, print, print again! Surely it is only a matter of time before the QE3 leaves the dock to follow her sister ship out into uncharted waters.

***

The dollar has indeed been much stronger of late, two possible reasons for which are mentioned above. This implies that dollar-denominated debt has become more rather than less expensive to service in real terms. This is in direct opposition to what the Federal Reserve is trying to achieve with QE2, which is to raise the rate of inflation. But because the Fed is now buying up Treasuries, it is not as if the US is suddenly going to face a funding crisis like Ireland. However, just as US Treasury debt has recently become more expensive to service, so has that for US states and municipalities. Here is where things are going to get much more interesting before long.

Relative to the debt crises facing a number of US states, the Irish debt crisis is but a storm in a teacup. California, for example, has an economy nearly TEN TIMES the size of Ireland. New York and Illinois, in comparably dire financial straits, have economies some FIVE TIMES and THREE TIMES the size of Ireland, respectively. All three states are struggling to service their debts amidst rising financing costs. As a result, these state governments are seeking ways to raise taxes and cut spending. But wait a minute: Not only do these states have large debt burdens; they are relatively high tax states; they are growing weakly; they have governments which appear gridlocked and generally unable to take decisive action to reduce spending. Well, what happens if state residents begin to consider the possibility that it might be better just to default than to saddle their families with huge debt burdens? What are investors going to think about that? Will they panic and dump the debt, as they already have done with Ireland and Greece and are now doing with Portugal and Spain?

What about US businesses? Wouldn’t it be better for profitable small businesses or wealthier, higher-rate taxpayers to move to lower-tax states? Indeed, there is evidence that this is already taking place, as the three states listed above have been losing population to lower-tax states in recent years. This, of course, shrinks the future tax base available to service the exponentially growing debt, something investors will no doubt fail to notice.

There is much schadenfreude in the US and to a lesser extent UK financial press regarding what is happening in the euro-area periphery, how poorly-designed the eurosystem is, how profligate member governments have been and how a big blowup is inevitable. But this schadenfreude is misplaced. Step back, take a look at the bigger picture and notice the real and growing similarities between the US and the euro-area. Consider that, when you add state and municipal debts to the federal total, the overall US government debt burden and that of the euro-area are comparable in size. (This is without taking future entitlements into account, which arguably would place the US is a somewhat worse relative position.) Also, when you add in state and local taxes–which are increasing on average–then the overall US tax burden is also comparable to the euro area. However, and this is an important distinction, the US has a huge net foreign debt position–the legacy of years of current account deficits–whereas the euro-area has no such external imbalance. The imbalances in the euro-area are internal instead, as the periphery runs a huge current account deficit with Germany and other core countries, which run surpluses.

When compared according to these important credit criteria, the US economy bears a much stronger resemblance to the euro periphery than to the euro core. Indeed, we would argue that this similarity is growing rapidly as US state and local debt and tax burdens rise; as unfunded federal mandates such as healthcare increase; as stricter regulations for all kinds of business, big and small, stifle traditional American entrepreneurialism and replace it with rent-seeking activities (and associated corruption) at all levels of government.

Although a few more dominoes in Europe are probably yet to fall, there is a huge stack waiting on the other side of the Atlantic. We have written before that we consider it highly likely that the US will face some sort of debt and dollar funding crisis before the end of 2012. The current, rapid pace of events on the euro periphery should not elicit schadenfreude from the US, but rather foreboding.

***

Early this year, when we published the inaugural issue of the Amphora Report, we listed the three key assumptions behind our core investment approach:

•The dollar no longer provides a safe or reliable store of value;

•There is no obvious alternative to replace it, dramatically increasing regime uncertainty;

•Diversification, the only “free-lunch” in economics, is the best protection against the unknown

Subsequent events have only reinforced our conviction in these assumptions. Not only has an increasingly desperate, pathological Fed embarked on a policy of deliberate dollar devaluation–as explicitly mentioned in the recently released November meeting minutes–the euro-area now faces an acute sovereign debt crisis; Japan has intervened to weaken the yen; Brazil and South Korea, among other countries, are increasing taxes on foreign “hot-money” capital flows; and China and India face sharply rising inflation which threatens to derail their booming economies.

Everywhere you look, there are increasing risks to currencies, sovereign bonds, corporate securities and financial assets generally. The problem is, as pointed out above, there is just too much credit risk in the world and investors demand that it be reduced, by crisis if necessary. But how to avoid taking credit risk when even sovereign debt is at risk of default? When the world’s reserve currency, the dollar, is being deliberately devalued? There is only one asset class that has zero credit risk or devaluation risk: Unencumbered real assets. While in principle this includes property owned free and clear, with banks still on the hook for massive losses in residential and commercial lending, most of which are still not marked-to-market on balance sheets, we think it is too early to venture back into the property market. A much safer alternative is liquid commodities that can be traded for other goods, or services, all over the world. These cannot be defaulted on. They cannot be devalued by central banks or governments. As such, in a world of unstable currencies and financial markets generally, a well-diversified basket of liquid commodities provides the best available store of value until the reduction in credit risk has run its course, one way or the other. As global debt levels are still rising, we have a long, long way to go yet.

Resources

[1] We borrow this title from the late Milton Friedman, author of Money Mischief: Episodes in Monetary History, although the conclusions we reach in this section have little in common with those of Friedman in this book.

[2] In a classic example of truth being stranger than fiction, the story of the creation of the Federal Reserve System is almost too fantastic to be believed, including a secret railway journey, code names and cryptic communications, and an elaborate, pro-active plan of public deception. No, this is not a wacky conspiracy theory but rather a well-documented series of historical events. At least two historians, William Greider and G. Edward Griffin, have written extensive books on the subject.

[3] This quote and all subsequent quotes here from Mr Griffin can be found in the text of this speech here.

[4] The most recent dissenter has been Thomas Hoenig of the Kansas City Fed, who has dissented at all FOMC meetings in 2010. Next year, however, he will rotate out of the voting, presumably removing a source of constant irritation for the neo-Keynesian inflationists who comprise the bulk of the current FOMC membership.

[5] An outstanding, compelling presentation of this argument is available in Thomas Woods, Jr’s book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse.

In financial market jargon, this effect is referred to as “contagion”, in that there may or may not be a direct, fundamental link between two assets or asset classes, but if they are correlated in some way–and most risky assets are, as positions are generally financed in similar ways, with similar collateral–then contagion across a wide range of assets can be sudden, widespread and unpredictable. The collapse of Long-Term Capital Management (LTCM) in 1998 is understood to have proceeded much in this fashion, as the Russian default in August that year cascaded into sharp declines for previously uncorrelated assets.

The Amphora Liquid Value Index (through 30 November 2010)

Source: Bloomberg LP

THE AMPHORA LIQUID VALUE INDEX represents the return on a dynamically-rebalanced portfolio of broadly and efficiently diversified commodities and currencies, intended to retain its real value in a wide variety of circumstances, including both inflation and deflation.

AMPHORA: A tall, lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean.

AMPHORA CAPITAL is dedicated to helping clients preserve wealth in a highly uncertain global environment by developing investment strategies protecting against both inflation and deflation.

John Butlerjbutler[at]jb-cap[dot]com

John Butler has 17 years experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is an occasional contributor to various financial publications and websites.

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