Debtor's Prison

Greetings fellow inmates:

On 05.13.09, Uncle Merv and Co. released their quarterly Inflation report, which gives a detailed look at the Monetary Policy Committee’s view on the economy and the inflationary outlook. We highly recommend you read it as it discusses the vicissitudes of monetary and economy trends in the UK. As usual, we will give you an executive summary, extract some notable graphs and comment on aspects we find of interest.

• In terms of economic growth, the BoE sees a pretty balanced set of risks that are all-too familiar to all of us by now. On the one hand, weak global demand, natural economic adjustments in the UK, rising private saving and bank balance sheet restructuring will continue to create a drag on economic growth. Simultaneously, Uncle Merv, quite optimistically, thinks that massive monetary and fiscal stimulus packages and past drops in commodities will buoy the economy, and that growth will return within the forecast period (1.5 years). The takeaway is that they have no clue as to the direction of the economy since the balance of risks remains highly uncertain. What a surprise.

Another well-known condition was the fall in domestic demand, which saw a sharp downturn in large part caused by tight credit conditions. Consumer spending fell by 1% in Q4 08 and continued to fall into 2009 on weaker job prospects and a “desire to strengthen” their finances. We, for one, are starting to get tired of these euphemisms coming from official communications which only mask the underlying debt problem. The UK consumers were even more indebted than their US counterparts, and this huge drop in demand is due to a forcible debt reduction/pay-down more than a prudential increase in savings. To say otherwise is to belittle the issue and completely ignore the problem of excessive individual and corporate leverage.

• On the inflation front, they cite (again!) an opposition of two forces. Lower commodity prices, spare capacity in the economy and weak labor markets are mentioned as the main causes behind the fall in inflation. Interestingly, as the main threat to inflation they cite the plummet of the Great British Peso (GBP). Remember that we have theorized that in the US, and the rest of the world by consequence, superinflation will come about through a great devaluation of the USD. The United Kingdom is currently experiencing a taste of what’s to come. CPI inflation remained near 3%, significantly above their target of 2%. Though the report states that inflation might fall below 2% by the end of the year, this is contingent on QE staying at its current levels. Given the falling levels of reserves worldwide, we would expect QE-on-Thames to continue increasing, as it has taken the role previously occupied by savings created by productive means. This increase will surely drive up yields and lead to a deterioration in the value of the GBP.

Notice that the CPI chart, in contrast to the GDP one, does not show the error distributions for the past; perhaps they didn’t want us to know how bad their estimates really were. This CPI forecast distribution was in general higher than in February’s Inflation report. It is no secret that we believe that a superinflationary scenario for the major “reserve currency” economies, and the rest of the world, is likely given the gargantuan increases in central bank balance sheets, and the massive fiat currency devaluation that will likely come about as a result. Moreover, in QE-on-Thames: Uncle Merv comes to town, we have predicted that Uncle Merv will be the first one to lose the battle to superinflation, defined as 25% per year.

On May 7^th, Uncle Merv decided to increase the size of QE by 66.6%, from £75bln to £125bln. Below, we see a chart of how the Asset-Purchase program has been going up to May 7^th. In contrast to Uncle Benny’s QE, QE-on-Thames has been growing smoothly in time, not that it matters.

The graph below shows the effect of QE on the gilt portfolios of different sectors. Notice that once QE began, all sectors sold gilts, including non-residents. This is a very significant point, as it illustrates the lack of demand for gilts from all spheres. We expect that this drop in demand is the reason that Uncle Merv had to increase QE. Let us repeat that this is the same mechanism that is happening in the US; a decline in demand for long-term sovereign debt from these “reserve currency” countries that has forced their central banks to ramp up QE. Moreover, we expect this cycle to continue. It irks us beyond normality that this driving factor for QE is never mentioned by official sources. Instead, we are sold the lie that the asset purchase programs are meant to boost nominal demand and to ease private credit markets. This of course is due to political motivations since it is easier to sell the idea of an inflationary program of dubious and uncertainty efficacy under the guise of supporting the economy rather than as a compulsion of over-leverage and the breakdown of the demand that permitted it in the first place.

As we can see from the chart below, yields fell precipitately following the announcement of QE in March. However, they have widened significantly since then, almost giving up their earlier tightening. According to the report, this could have been in large part due to increased concerns following upwardly-revised government borrowing expectations in April. In our opinion, this is an honest admission, and a direct statement that should serve as a forewarning. Debt levels cannot continue increasing unabatedly without a rise in yields, in spite of QE. In fact, QE will likely make the problem worse, as we have seen in both the US and the UK, the actual purchases themselves have not kept yields from rising.

The report also mentions broad money and how it has grown only slightly. As stated, the BoE uses M4 as a barometer of nominal demand since it is the most liquid measure of money holdings of those entities most likely to affect prices and spending. M4 essentially measures the amount of money holdings, ie deposits, of a variety of sectors. The graph below is quite striking for the following reasons. It shows M4 growth with and without intermediate “OFCs” (other financial institutions). Intermediate OFCs are institutions that specialize in intermediating between banks, such as central clearing houses and Securitization Special Purpose Vehicles (SPVs). Remember that SPVs were the roots of the shadow banking system that banks used to hide off-balance sheet assets and liabilities. With this in mind, look at the huge difference in money growth when you exclude intermediate OFCs. What this tells us is that the vast majority of the liquidity and new base money created has gone to these SPVs and other intermediaries and to prop up the shadow banking system. At the very least, it completely shatters the notion that the monetary stimulus has trickled down to the basic economy to any significant degree.

On a related note, bank lending to households has decreased drastically as can be seen in the graph below. As we saw in What if the Money Multiplier model doesn’t work, this credit creation is believed to lead to the increase in the broad monetary aggregates, in this case M4, which in turn leads the creation of base money. In other words, this fall in lending to households (and businesses) is highly correlated with the fall in M4 excluding intermediate OFCs.

To put it even more bluntly, it is this drop in bank lending that has directly caused a sharp reduction in M4 growth. Meanwhile, all the liquidity injection is going to the SPVs of those same institutions that are restricting lending. This is nothing new, we all knew this. But what we want to illustrate is how the data seems to scream to us that this is so and in such a flagrantly visible manner. It currently seems as if there is NO transmission channel through which the central bank can compel the banks to lend again, thus creating a deflation of the broad monetary aggregates that exclude the shadow banking system and the clearing houses. If our hypothesis is correct, then this is a complete sham because the banks are ultimately in direct control of the broad money supply (and thus of inflation to an extent) moreso than the central bank is and could choose to regulate it as they pleased. In our current situation, we have the central bank providing as much liquidity as necessary and pledging to support any of the systemically important institutions. The banks could easily agree to comply with a desired level of lending, contingent the central bank agrees to provide liquidity and lender-of-last-resort as they have. This would create more of a direct lever over the level of monetary aggregates than the illusion of the flawed money multiplier method.

This is not to say that we advocate doing this, but rather to illustrate how easily the alleged problem of falling M4 growth could be solved if there was an actual desire to do so on the parts of authorities and banks. As is often the case, the question seems to be, why are central banks reticent to compel banks to lend if they are in fact so concerned over deflation? Much has been said about lack of credit demand, but we are not convinced that, if given the opportunity, the majority of people wouldn't refinance rather than default. Even Uncle Merv’s report says how the majority of recent private corporate debt issuance is meant for restructuring rather than for new projects. Ultimately, it seems like the banks are refusing to do something that would allegedly solve one of Uncle Merv’s problems, a shrinking M4. Why are they doing that? Why continue to hoard cash? The most rationally expected reason is that the banks simply don’t expect to make more money lending than by hoarding cash. Perhaps they could make more money if they start lending only once interest rates come up again. In general, they could rather prefer to borrow money when interest rates are so low and lend it back once they rise. Or perhaps they are holding on to cash in expectation of a massive consolidation phase. We believe it’s a combination of both, but the debate is far from over and your guess is as good as ours. Ultimately the salient point is that banks seem to be playing very hard to get with something Uncle Merv really seems to want, a solid M4 growth. Uncle Merv is getting owned so badly, it’s pathetic. Come on, Uncle! Get your chin up!

Finally, we leave you with a little ridiculous diagram that is supposed to clarify how QE is supposed to work and do it’s job. We won’t go into detail on the many flaws in this thought diagram, we leave it up to you dear reader to make your own long list. All we advice for you to solve is puzzle is to ask yourself the following questions. At each arrow in the diagram, ask yourself “who is the intermediary and how do they benefit? Then, determine the mechanism through which it’s supposed to work (ie: direct purchase, etc). And finally, ask yourself, what could go wrong with the mechanism. These three questions should be enough to reveal this diagram in all its flawed, misleading, naïve and ill-defined ignominy.

May your capital be safe and your investments prosperous,

MAAA