July 5 2009: The unbearable mightiness of deflation

George N. Barnard Old Dixie's Down1864
A passel of Yankees in repose at federal picket post near Atlanta, Georgia

Stoneleigh: A recent article by Gary North, entitled Pushing on a String, has ignited another round in the inflation/deflation debate. Our readers at The Automatic Earth have repeatedly asked us for comment. The topic still remains a confusing one for many. To shine some light, let's use Mr North's words against him, shall we?

My first impression on reading "Pushing on a string" is that it is distastefully egotistical, dismissive of a position that is obviously not understood, and very likely to cause confusion due to the misuse of terms. Rarely do I find the writing of others grating on a personal level, even if I disagree with their position, but in this instance I would have to describe both the initial article and Mr North's response to analyst and web writer Mike (Mish) Shedlock's very valid criticism of it as pompous and ill-informed. That out of the way, let’s talk meat and bones.

Mr North frames the dichotomy between inflation and deflation in price terms, which does nothing but muddy the waters. Those who argue for deflation (whom North describes rather contemptuously as "a tiny band of intrepid non-economists who have seen their founder's prediction refuted by the facts in every year since 1973") do so on the basis of inflation and deflation as the monetary phenomena they are, rather than as price movements.

This is fundamental to the argument, hence attempting to refute that argument by deliberately using the terms to refer to something different is disingenuous. He does use the term 'price inflation' but does not make clear the importance of the distinction between price movements and changes in the money supply. Nor does he distinguish between prices in nominal terms versus real terms, which is vital to understanding what is happening to affordability.

As we have consistently explained here at The Automatic Earth, inflation is an increase in the supply of money and credit relative to available goods and services, while deflation is the opposite. Deflation, moreover, is aggravated by a collapse in the velocity of money. Price movements are lagging indicators of monetary changes, but are also subject to a number of other drivers, such as scarcity and substitutability (or lack thereof).

For this reason, price movements alone have no explanatory or predictive value. For instance, we have lived through a highly inflationary credit expansion over the last couple of decades, but prices have not reacted consistently. Some have risen, as one would expect, but others have fallen, due, for instance, to the effects of global wage arbitrage. For prices to fall in nominal terms during inflationary times, they must be going through the floor in real terms.

Deflation would be associated, at least initially, with prices falling across the board, as the collapse of purchasing power would drastically reduce price support for virtually everything. In a deflation, people sell anything they can, in order to pay down debt, to meet margin calls and to cover the cost of living, once access to credit is cut off and earning an income becomes very much more difficult. This is a recipe for prices falling by perhaps 90% in nominal terms, but for goods and services to become simultaneously much less affordable, as purchasing power would be falling even faster. In other words, in real terms, prices rise (i.e. affordability decreases). 



As a much larger percentage of a much smaller effective money supply would be chasing essentials, these would receive relative price support, making them even less affordable than everything else. If we later see scarcity of essentials, due to the collapse of global trade and the just-in-time economy, it is possible that prices would begin to rise again in nominal terms despite deflationary deleveraging. For nominal prices to rise during deflation, they would have to be going through the roof in real terms. The interaction of various factors will determine prices, but the deflationary contraction of credit is a given, and deflation can render things unaffordable far more quickly and comprehensively than inflation.

An understanding of the scale of the inflation we have lived through requires far more than looking at CPI or even casting an eye over conventional money supply measures. It is necessary to appreciate the role of credit and the massive scale of a credit expansion that largely took place in the unregulated shadow banking system. Credit is the critical factor, as the 'moneyness' of credit in a myriad different manifestations drove the expansion of the effective money supply.

As John Rubino explained in 2007:

”Doug Noland has for years been pointing out that one of the drivers of the credit bubble has been the ever-broadening definition of money. As the global economy expanded without a hic-up, more and more instruments came to be used as a store of value or medium of exchange or even a standard against which to value other things—in other words, as money. Thus mortgage-backed bonds and even more exotic things came to be seen as nearly risk-free and infinitely liquid. In Noland's terms, credit gained "moneyness," which sent the effective global money supply through the roof. This in turn allowed the U.S. and its trading partners to keep adding jobs and appearing to grow, despite debt levels that were rising into the stratosphere. For a while there, borrowing actually made the world richer, because both the cash received and the debt created functioned as money.”

Mish agrees in his response to Gary North:

"We have a credit based economy and anyone watching money supply and not watching credit is simply wrong. This is a statement of fact, not idle conjecture."

Mish is right. However, credit only functions as equivalent to money during the expansionary phase. Once the credit ponzi scheme has reached is maximum extent, the quality of 'moneyness' disappears. As the value of credit collapses, so does a money supply of which credit has come to comprise the vast majority. This is deflation, not the fall of prices, and there is precious little central bankers can do about it other than to play a desperate confidence game, hoping that they can obscure reality long enough for confidence to return by itself.

It isn't going to work. Their actions, in combination with natural swings in herding behaviour, can postpone, but not prevent a credit collapse. Mr North says:

"... deflationists argue that the economy is in a deflationary spiral that the FED cannot prevent. They do not know what they are talking about. They never have."

In reality, it is he who shows no understanding of the importance of credit and the impotence of the FED in combating its collapse.
 
John Rubino again:

”With a few months of hindsight, it's now clear that debt-as-money was not one of humanity's better ideas. When the U.S. housing market -the source of all that mortgage-backed pseudo money- began to tank, hedge funds found out that an asset-backed bond wasn't exactly the same thing as a stack of hundred dollar bills. The global economy then started taking inventory of what it was using as money. And it began crossing things off the list. Subprime ABS? Nope, that's not money. BBB corporate bonds? Nope. High-grade corporates? Alas, no. Credit default swaps? Are you kidding me?
 
No longer able to function as money, these instruments are being "repriced" (a slick little euphemism for "dumped for whatever anyone will pay"), which is causing a cascade failure of the many business models that depend on infinite liquidity. The effective global money supply is contracting at a double-digit rate, reversing out much of the past decade's growth.”

Even as it seeks greater and greater powers, the FED is not omnipotent. Its reach is limited, particularly in relation to the shadow banking system, as Henry Liu pointed out in 2007:

"As an economist, Ben Bernanke, the new Chairman of the US Federal Reserve, no doubt understands that the credit market through debt securitization has in recent years escaped from the funding monopoly of the banking system into the non-bank financial system. As Fed Chairman, however, he must also be aware that the monetary tools at his disposal limit his ability to deal with the fast emerging market-wide credit crisis in the non-bank financial system.
 
The Fed can only intervene in the money market through the shrinking intermediary role of the banking system which has been left merely as a market participant in the overblown credit market. Thus the Fed is forced to fight a raging forest fire with a garden hose."

Here’s  Mish again, from 2008, making clear the limitations of money printing in an attempt to prevent deflation in a fiat regime:

”Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed.

These are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark. Yes, there was deflation in Japan. Furthermore, if deflation can happen in Japan, then there is no reason why it cannot happen in the US as well.”

We are on the verge of a deflationary debt default tsunami. More and more individuals, companies and governments at all levels are approaching the point where servicing their debts will no longer be possible. Quantitative easing will eventually greatly exacerbate the difficulty this poses by risking a seizure in the bond market that would send interest rates into the double digits.

For the time being though, we have very low nominal interest rates. Mr North argues that this should spur lending, as money is essentially free:

"At some low price – such as "free" – people will take the money. That's why price inflation is in our future. Price deflation isn't, short of a banking gridlock, which is quite possible, but an unpredictable event”.

It is, however, real interest rates that matter, not nominal rates. Money offered at zero percent interest in nominal terms is not free if the effective money supply is contracting, as the real rate of interest is the nominal rate minus negative inflation. The Fed is pushing on a string as even zero is not low enough. And banking gridlock is not an unpredictable event under the circumstances we are facing. On the contrary, it is to be expected.



 
Money is actually free when real interest rates are zero, or even negative, as they were in the years following the tech-wreck. Low nominal interest rates against a backdrop of a rapidly expanding credit pyramid was an invitation to take on unsustainable levels of debt if ever there was one, and both borrowers and lenders took full advantage of the opportunity. Borrowers thought only of their low monthly payments and lenders thought only of the fees they were earning by setting up loans and selling them to Wall Street in the form of securities. Lending standards hit a new low as credit-worthiness was forgotten.
 
Both parties are now living to regret their previous excesses, but the damage is done. Now that credit is contracting, that 'free money' has turned into unpayable debts and illiquid asset markets, which will eventually have to be marked-to-market. Now balance sheets must be rebuilt and neither borrower nor lender is willing to dig themselves into an even deeper hole. The velocity of money will inevitably fall dramatically as risk aversion rises, reserves are held again looming defaults and cash is hoarded. The scale of the bad debt in our global economy is gargantuan. The Fed cannot midwife credit creation under those circumstances, and things will get much worse before they get better.
 
Mish, in response to Gary North:

"Of course those "excess reserves" are a mirage; they don't really exist. Banks need those reserves because of the massive wave of credit card defaults and foreclosures yet to hit the books. Every uptick in unemployment exacerbates credit card losses, foreclosures, losses on home equity loans, etc, something that Gary North ignores."

Mr North dismisses the role of credit and the impact of its contraction summarily, stating:

”Those forecasters who are predicting price deflation argue that monetary inflation will not be powerful enough to overcome price deflation. Nobody is predicting an actual decrease in the money supply, short of some sort of banking gridlock and a complete breakdown of monetary transactions, which no conventional analyst even considers, since it is just too pessimistic to consider seriously, like nuclear war.”

Commentators are predicting an actual decrease in the effective money supply. If conventional analysts are not, then they need to broaden their understanding of what constitutes the money supply in practice. Saying that something cannot happen because the impact would be severe is a non-argument. Serious negative events do occur, and the circumstances leading to this one are obvious. We are headed for banking gridlock and a breakdown of monetary transactions, as we did in the 1930s, only this time it will be worse, as the excesses leading up to this crisis have been worse in every way than they were in the Roaring Twenties.
 
Finally, Mr North has a distressing tendency to personalize his criticism of his intellectual opponents in a particularly patronizing manner. His leading criticism of Mish for instance, is that, as a photographer, Mish could not possibly have the time to be a credible economic commentator:

"It takes years to build this sort of portfolio. You must eat, drink, and sleep photography. You must master the tools of the trade. You also need creativity. This is not a part-time occupation. It is not a hobby. It is a career. I know what it takes. I used to be an amateur photographer. I gave it up in 1960. I knew I did not have the time to become really good and also pursue my work in economics, history, and markets. I had to choose."

He would no doubt make a similar criticism of me, were he aware of my existence, as I am also an inter-disciplinarian. Not everyone is forced to choose one field to the exclusion of all else in order to understand the fundamentals of that field. In fact, building an appreciation of the bigger picture requires a broad view. In order to understand the scope of our predicament, it is necessary to understand finance, but also energy (net energy, EROEI, receding horizons etc), ecological carrying capacity and population, collective psychology and herding behaviour (see Prechter), diminishing marginal returns to socio-economic complexity (see Tainter), catabolic collapse (see Greer), positive feedback loops, adaptive ecological cycles (see Holling),  pollution and pathogens, game theory, real politik, risk dynamics, reality versus perception as socioeconomic drivers etc, etc. Breadth and depth are not mutually exclusive, and the narrowly focused approach will only take one so far. I think Gary North has some serious reading to do.
 
Note: I have not answered Mr North's 10 questions for deflationists, as he frames the debate in terms that serve to obscure rather than illuminate the important factors. The fundamental criticism of Mr North's position is that he fails to recognize the role of credit and the nature of deflation.
 
My position on the financial aspect of our predicament can be found here:
 

• The Resurgence of Risk - A Primer on the Developing Credit Crunch
  
• Inflation Deflated
  
• From the Top of the Great Pyramid
  
• Markets and the Lemming Factor

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Ilargi: Sometimes it’s real funny to see your own predictions mirrored in the media, and presented as entirely new. Today, BusinessInsider's Joe Weisenthal talks about Joe Biden's stint at George Stephanopoulos’ "This Week" this morning:

We predicted on Thursday, after the weak jobs report, that the second stimulus was no definitely on its way. The very next day, Paul Krugman, a reliable thermometer for establishment thinking, chimed in and said we must do a second, bigger stimulus.

Thursday? Hmm... Let me take you back to last Sunday, when I wrote this about George Stephanopoulos’ interview with White House Special Adviser David Axelrod:

Ilargi: "Last Friday, I named my daily post "Never deny beating your wife"[..]. The line is straight out of PR and media training 101: how to avoid digging yourself into a hole when asked questions phrased in particular ways. Or, alternatively, how to dig a hole for someone you ask a question. Note: the actual question is slightly different and more devious: "When did you stop beating your wife?" [..]

This principle works in more ways than one. People who've done the PR 101 course, and more, can for instance use it to say things by not saying them. That is what White House Senior Adviser David Axelrod did this morning on ABC's "This Week With George Stephanopoulos", and I wouldn't want to bet George wasn't in on it..."

(Axelrod told George last Sunday:"...most of the stimulus money, the economic recovery money is yet to be spent. Let's see what impact that has. I'm not going to make any judgment as to whether we need more." )

"There are plans being prepared, if they're not already fixed, for a second stimulus plan, By not denying, he admits it. It may not look that way at first sight, but it's there. Stephanopoulos quotes Krugman (and more economists) as saying that a 9-10% unemployment rate in September will necessitate a second stimulus package. Axelrod has no denial, he doesn't even try, silently implying that Krugman is correct. He simply says: "I don't want to prejudge that at all."

The position the White House is in is precarious. People need to be prepared for a deteriorating economy, and therefore for that next stimulus package. But the speed at which the first stimulus is being spent is ridiculously slow. [..]

So while the first stimulus plan is in a shambles, and the economy is fast sinking, as is evident from unemployment and real estate stats, the government needs to prepare the nation for more taxpayer funded spending. Obama and Tim Geithner can't touch that topic with a ten foot pole, not for quite a while. So they send out the support troops, in today's case Axelrod and Christina Romer."

(And a week later it’s Joe Biden, who has no accountability related fears that threaten the president for now.)

They can't get the finances and economics right, but they have one hell of a PR and spin team. Don't underestimate the degree to which this administration is run by that team.

Now, that may amuse me. What does not is that the US vice president lies to the people's faces, aided and abetted by Stephanopoulos (I was right about his part too, he's "in on the fix").

Biden said this:

"The truth is, we and everyone else misread the economy."

And that is a blatant lie on more than one front. First, not everyone else misread the economy. That is easy to prove, all you need to do is read the archives here at The Automatic Earth. No two ways about it. Sure, the White House may not read us. But they do follow Krugman, Roubini and a large group of other, "more serious" commenters. And so they could have known, and they did know. They didn't misread the economy. They simply didn't tell the people what they knew.

The administration feeds the misery to the people bite-size, that is why their messages 6 months ago were so different from today. It's not that they didn't know, it's that they polled enough to understand that their poll numbers would have gone down if they told the truth.

So now Joe Biden is being trotted out to deliver the next set of lies. The message has to be massaged into the minds of the people, but Obama can't do it. The lies have to be delivered, but Obama has to be kept far enough away from them to wash his hands clean if need be.

Meanwhile, government officials lie to their people's faces, and the media willingly helps them do so. Look, Stephanopoulos is not dumb. he doesn't buy the "nobody saw this coming" line one bit. So why doesn't he challenge Biden on it? Simple: he's part of the delivery mechanism. Last week with Axelrod, today with Biden.

I’m looking through the net for voices crying out loud their insulted anger about Biden's blatant black lies, and there's nothing there.

That is how you recognize a full-blown political crisis.

Biden: We Blew It On The Economy

Joe Biden told "This Week" that the Obama administration "misread how bad the economy was."  He also the administration made this mistake because they just looked at the consensus forecasts at the time...and they proved to be wrong. If the latter is true, the administration deserves the crap it has been getting.  In the months leading up to Obama's inauguration, the economy fell off a cliff.  The credit markets seized up.  Several major investment banks went bust. 

The Fed and Treasury talked of an apocalypse.  Everywhere you looked, you heard one analyst after another saying the country was plunging toward another Great Depression. If anything, the economy since the inauguration has been better than many analysts feared.  So this "we didn't get it" sounds like revisionist history to us.  More likely, in our opinon, the administration concluded that it would never get its huge spending increases passed if its projections reflected the "most likely" scenario for the economy.  And so it produced the economic forecasts (growth, stress tests, jobs, etc) that have begun to destroy Obama's credibility on this critical issue.

Regardless of the thinking behind the over-optimism, Obama has made a serious error here.  Recovering from financial disasters like this usually takes years--and it likely will this time, too, regardless of what Obama does.  Above all else on the economy, Obama had to under-promise and over-deliver.  By promising a relatively swift recovery, he has set himself up for failure.  If the economy does recover, he'll be fine, but if it doesn't (which seems more likely), he will increasingly be blamed for failing to fix it.  And given the singular importance of this issue to most Americans right now, it is hard to see how his presidency will survive that.

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Biden's Just Setting Up The Second Stimulus

So did Joe Biden just pull another "Biden" with his line this morning about "misreading" how bad the economy was?

Some folks in the White House may chalk it up to "Joe being Joe," but make no mistake, the administration is laying the groundwork for the second stimulus.

We predicted on Thursday, after the weak jobs report, that the second stimulus was no definitely on its way. The very next day, Paul Krugman, a reliable thermometer for establishment thinking, chimed in and said we must do a second, bigger stimulus.

So when you have Joe Biden saying "we misread how bad the economy was" -- despite the fact that we stave off an outright collapse -- what else could he possibly be talking, other than: 'it's time to do a second stimulus'?

So how will this be sold politically? Here's a guess. The administration and Congress will argue (correctly) that the first stimulus wasn't actually a stimulus, but was mainly an expansion of various benefits and transfer payments. Stuff like that. This time, they'll say, those gargantuan stimulus projects will be the priority, and they'll say that the original stimulus demonstrated an enormous demand for cash to fund infrastructure projects, all around the country.

The question then, is timing. Our guess is October.

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Biden: We 'Misread the Economy'

Big admission from Vice President Joe Biden today. "The truth is, we and everyone else misread the economy," Biden told me during our exclusive "This Week" interview in Iraq. Biden acknowledged administration officials were too optimistic earlier this year when they predicted the unemployment rate would peak at 8 percent as part of their effort to sell the stimulus package. The national unemployment rate has ballooned to 9.5 percent in June -- the worst in 26 years.

"The truth is, there was a misreading of just how bad an economy we inherited," said Biden, who is leading the administration's effort to implement it's $787 billion economic stimulus plan. "Now, that doesn't -- I'm not -- it's now our responsibility. So the second question becomes, did the economic package we put in place, including the Recovery Act, is it the right package given the circumstances we're in? And we believe it is the right package given the circumstances we're in," he told me.

The vice president argued more time is needed for the stimulus to work. "We misread how bad the economy was, but we are now only about 120 days into the recovery package," he said. "The truth of the matter was, no one anticipated, no one expected that that recovery package would in fact be in a position at this point of having to distribute the bulk of money." Biden didn't rule out a second government stimulus package, but downplayed calls from Nobel Prize-winning economist Paul Krugman this week that a second stimulus will be needed.

I pressed the vice president, who is also leading the administration's middle-class task force, on whether he'd rule out a second stimulus package.

"So, no second stimulus?" I asked. "No, I didn't say that," Biden said, "I think it's premature to make that judgment. This was set up to spend out over 18 months. There are going to be major programs that are going to take effect in September, $7.5 billion for broadband, new money for high-speed rail, the implementation of the grid -- the new electric grid. And so this is just starting, the pace of the ball is now going to increase."

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>A Goldman trading scandal?

Did someone try to steal Goldman Sachs’ secret sauce? While most in the US were celebrating the 4th of July, a Russian immigrant living in New Jersey was being held on federal charges of stealing top-secret computer trading codes from a major New York-based financial institution—that sources say is none other than Goldman Sachs.

The allegations, if true, are big news because the codes the accused man, Sergey Aleynikov, tried to steal is the secret code to unlocking Goldman’s automated stocks and commodities trading businesses. Federal authorities allege the computer codes and related-trading files that Aleynikov uploaded to a German-based website help this major “financial institution” generate millions of dollars in profits each year.

The platform is one of the things that apparently gives Goldman a leg-up over the competition when it comes to rapid-fire trading of stocks and commodities. Federal authorities say the platform quickly processes rapid developments in the markets and uses top secret mathematical formulas to allow the firm to make highly-profitable automated trades. The criminal case has the potential to shed a light on the inner workings of an important profit center for Goldman and other Wall Street firms. The federal charges also raise serious questions about the safeguards Wall Street firms deploy to protect their proprietary trading systems.

The criminal case began to unfold on the evening of July 3 when Aleynikov was arrested by FBI agents at Newark Liberty Airport, after returning from Chicago. Aleynikov had just started a job with another firm in Chicago, after leaving the big firm in NY in early June. It appears the financial institution allegedly victimized by Aleynikov had alerted federal authorities that its former employee might be up to no good.

On July 4, Aleynikov was processed on a “theft of trade secrets” charge in a criminal complaint that was filed in federal court in Manhattan. As of this afternoon, he was still being held in federal custody pending posting of bail. A Goldman spokesman declined to comment on the incident. Calls to Aleynikov’s home in New Jersey, which he shares with his wife, were not returned. A spokeswoman for the US Attorney in the Southern District of New York didn’t comment.

Sabrina Shroff, Aleynikov’s lawyer, says the facts will bear out that her client is innocent. She’s hoping he will be released from custody soon. The Federal Bureau of Investigations, in charging Aleynikov, says he began working for the major financial institution in May 2007 as a computer programmer and left in early June. That would appear to match the description of a man  named Serge Aleynikov, as it is listed on the social networking website LinkedIn.

The bio information for Aleynikov on LinkedIn says he joined Goldman in May 2007 and was vice president for equity strategy. The bio says he was responsible for “development of a distributed real-time co-located high-frequency trading platform.” In his own words, he goes on to describe the platform as “a very low latency (microseconds) event-driven market data processing, strategy and order submission engine.” The case against Aleynikov may explain why the New York Stock Exchange moved quickly in the past week to stop reporting program stock trading for its most active firms. Goldman often was at the top of the chart–far ahead of its competitors.

On the week ending June 19, Goldman was ranked first on the NYSE program trading list. But on the week of June 22, Goldman mysteriously didn’t appear on the list of the top 15 firms at all. It simply vanished without any explanation. Then the NYSE stopped reporting the numbers. The Zerohedge blog was all over this controversy a week ago. And now Tyler Durden of ZeroHedge has come in with his own excellent analysis of this strange, strange criminal case. I highly recommend reading it. It’s possible Goldman asked the NYSE to stop reporting the number after it discovered that someone may have infiltrated the proprietary computer codes it uses.

Here’s the way the criminal complaint describes the Goldman trading platform:

The Financial Institution has devoted substantial resources to developing and maintaining a computer platform that allows the Financial Institution to engage in sophisticated high-speed, and high-volume trades on various stock and commodities markets. Among other things, the platform is capable of quickly obtaining and processing information regarding rapid developments in these markets. Meanwhile, federal authorities appear to believe Aleynikov, who has lived in the US for more than a dozen years but frequently travels back-and-forth to his native Russia, may have had help.

The German website that Aleynikov allegedly uploaded the stolen information to is registered to a person in London. That, of course, gives rise to speculation about this all being a case of international espionage. This case is quickly unfolding and there’s plenty more information to unearth about Aleynikov. For instance, it appears that he and his wife are competitive ballroom dancers–there are some videos of them on youtube.com. The job he took in Chicago, according to the criminal complaint, paid nearly three times more than his $400,000 salary at Goldman.

Which Chicago firm hired Aleynikov? Inquiring minds want to know. But you can rule out the giant hedge fund conglomerate Citadel. It’s not them. Also there’s more to learn about anyone who might have been helping him and the fallout this may have for Goldman.  When he was arrested, Aleynikov told the FBI he “only intended to collect ‘open source’ files on which he had worked, but later realized that he had obtained more files than he intended.” But authorities say after he uploaded the files he encrypted them and “erased” the program he used to encrypt them.

It’s not clear why the authorities and apparently Goldman waited so long to move on Aleynikov, even though they knew he had uploaded the information weeks ago. One question investors need to ask is whether this incident will have any impact on Goldman’s second-quarter earnings. The alleged wrongoing by Aleynikov took place at the beginning of the month–although it’s not clear if it had any material impact on automated trading.

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Is A Case Of Quant Trading Sabotage About To Destroy Goldman Sachs?

Matt Goldstein over at Reuters may have just broken a story that could spell doom for if not the entire Goldman Sachs program trading group, then at least those who deal with "low latency (microseconds) event-driven market data processing, strategy, and order submissions." Visions of swirling, gray storm clouds over Goldman's SLP and hi-fi traders begin to form.

Back-up: This week's NYSE Program Trading report was very odd: not only because program trading hit 48.6% of all NYSE trading, a record high at least since the NYSE keep tabs of this data, and a data point which in itself was startling enough to cause some serious red flags as I jaunt from village to village in what little is left of Europe's bison country, but what was shocking was the disappearance of the #1 mainstay of complete trading domination (i.e., Goldman Sachs) from not just the aforementioned #1 spot, but the entire complete list. In other words: Goldman went from 1st to N/A in one week.

Even more odd, this "disappearance" comes hot on the heels of what Zero Hedge reported could be potentially a major change to the way the NYSE provides its weekly program trading report. Of course, Ray over at the NYSE immediately replied to Zero Hedge that all was going to be same as always ... Odd, maybe he meant that all is back to normal except the reporting of Goldman's trades. Either way, it might very well be time for proactive readers to again contact the two employees publicly disclosed by the NYSE as lead-contacts on the issue. Readers will recall that it was these same two who were previously steadfastly assuring anyone who would listen that there would be no change at all in data reporting.

Robert Airo, Senior Vice President, NYSE Euronext at (212) 656-5663 or
Aleksandra Radakovic, Vice President, NYSE Regulation at (212) 656-4144

Alas, the just released weekly data proves that either theirs was a material misrepresentation of facts, or Goldman simply suddenly decided to stop transacting with the NYSE, or, what would be even more sinister, Goldman notified the NYSE to scrap all their trading data from the prior week. Why would they do that?

Going back to Matt Goldstein's story. In a nutshell, on Friday, one Sergey Aleynikov was arrested at Newark airport by FBI agents, as he was coming back from a trip to Chicago (maybe visiting his new employer), on what are basically industrial espionage charges. Sergey, or Serge as his Linked-In account identifies him, was VP of equity strategy over at 85 Broad (or maybe 1 New York Plaza, his detailed Bloomberg Bio page has disappeared) had the following responsibilities at Goldman Sachs according to Linked-In:

• Lead development of a distributed real-time co-located high-frequency trading (HFT) platform.The main objective was to engineer a very low latency (microseconds) event-driven market data processing, strategy, and order submission engine. The system was obtaining multicast market data from Nasdaq, Arca/NYSE, CME and running trading algorithms with low latency requirements responsive to changes in market conditions.
• Implemented a real-time monitoring solution for the distributed trading system using a combination of technologies (SNMP, Erlang/OTP, boost, ACE, TibcoRV, real-time distributed replicated database, etc) to monitor load and health of trading processes in the mother-ship and co-located sites so that trading decisions can be prioritized based on congestion and queuing delays.
• Responsible for development of real-time market feed handlers, order processing engines and trading tools at a Quantitative Equity Trading revenue-making HFT desk.

If the allegations are true, it looks like Goldman's hi-fi quant trading desk was thoroughly penetrated by a "spy", and as readers will recall, Serge(y)'s description of his job duties mirrors what Mr. Ed Canaday conveniently provided to Zero Hedge as a description of Goldman's SLP program. (Sources connected with the office of the United States Attorney have confirmed to Zero Hedge that Aleynikov was at one time or another a Goldman employee.").

The plot thickens: per FBI agent Michael McSwain's sworn deposition, Sergey quit a firm described as "Financial Institution" in the affidavit, which according to circumstantial evidence and according to Goldstein is none other than Goldman Sachs, on June 5, at that time earning $400,000 annually. As Matt reports, he proceeded to move to a Chicago firm engaged in "high volume automated trading" where he would make 3x his $400k salary (Hey Getco, is it time for a formal release at least denying you guys had anything to do with this, cause if you did it might not look that hot. No matter, we have reached out to our sources in law enforcement to confirm or deny Getco's, and Goldman's, involvement: once we get a response we will immediately advise our readers).

In the 5 days immediately preceeding his departure from "Financial Institution" (potentially GS), Sergey allegedly downloaded 32 megs of ultra top-secret quant trading proprietary code, that, according to Special Agent McSwain's affidavit, he then proceeded to encrypt and upload to a website in Germany, with a UK owner. One can only imagine the value of this "code" not only to Goldman but to the highest bidder. After all, from the affidavit: "certain features of the [code], such as speed and efficiency by which it obtains and processes market data, gives the Financial Institution a competitive advantage among other firms that also engage in high-volume automated trading.The Financial Institution further believes that, if competing firms were to obtain the [code] and use its features, the Financial Institution's ability to profit from the [code]'s speed and efficiency would be significantly diminished." Needless to say, many others are now also likely hot on the trail of the code.

What is probably most notable, in less than a month since Sergey's departure from [Goldman?], the FBI was summoned to task and the alleged saboteur was arrested and promptly gagged: if anyone is amazed by the unprecedented speed of this investigative process, you are not alone. If only the FBI were to tackle cases of national security and loss of life with the same speed and precision as they confront presumed high-frequency program trading industrial espionage cases... especially those that allegedly involve Goldman Sachs.

Now the real question here is, does [GS?] feel lucky? Because the code has supposedly been in the hands of an outsider for over a month, one might suspect that anyone who wanted to has had ample opportunity - if the holder(s) wished to sell... Would that have anything to do with the even weirder than usual market action over the past 2-3 weeks: after all it is the very Goldman Sachs (which may or may not be the target of this program trading industrial espionage) which is the primary SLP on the world's biggest stock exchange.

Another major question: do Goldman and the NYSE not have a fiduciary responsibility to announce to both shareholders and any interested parties if there has been a major security breach in their trading operations? Certainly this seems like a material piece of information: given that program trading accounted for 49% of all NYSE trading last week, and Goldman as recently as one week ago represented about 60% of all principal program trading, will this be called an issue threatening the National Security of the United States. Shouldn't all market participants be aware that there is some rogue code in cyberspace that can be abused by the highest bidder, who very likely will not be interested in proving the efficient market hypothesis? What will happened when said bidder goes about trying to front run none other than the "Financial Institution" [GS]?

The complete affidavit can be downloaded from this post here, and is also provided Scribed below as this could (and likely should) become a matter of National Security. Zero Hedge will closely monitor this situation from the European hinterland and provide updates as they come. For really interested readers, we recommend tracking any potentially new developments on the forums and message boards over at Wilmott.

major hat tip Matt Goldstein of Reuters

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How to kill a zombie

Most of you are familiar with the usual plot of most zombie movies. Everything is fine until one day when space dust, a new virus, or occult practices start causing the dead to re-animate and spur within them an insatiable lust for human blood. The principals in the movies take some time in figuring out how to fight back, usually spending a lot of the time running from zombies coming from every direction. But then, at some point, someone realizes that the only way to stop the zombies is to shoot, puncture, explode their heads (and sometimes hearts in some movies).

The way you kill a zombie is to shoot it in the head.

Today, our banking system, is a zombie. Instead of hungering for human flesh directly, it hungers for our cash. But where is the head on this zombie located, where can we focus our actions to actually kill these zombies, rather than running from them with no hope of relief?

The answer lies with the concept of 'hot money.'

'Hot money' in the banking industry is officially known as brokered deposits. Say a community bank, with a long history of responsible lending in your town, decides that it wants to grow and be as profitable as the megabank down the street. The only way a bank can grow is by attracting more depositors. New toasters can only go so far in attracting new depositors in today's marketplace, but small banks have other alternatives.

Small banks can turn to the brokered deposits industry. A company like Merrill Lynch has large amounts of cash that have been invested by individuals and organizations into safe investments like certificates of deposit and money market funds. These investments are considered some of the safest and most secure out there. But Merrill Lynch isn't doesn't like the idea of having its equities investments (stocks, etc.) being used to cover the interest they guarantee with their cash investment opportunities, so they have created the brokered deposits market.

Merrill Lynch can offer to set up FDIC-insured deposits in that small community bank if the bank will offer them a preferential interest rate (a rate higher than a member of the community will get and that other small banks are offering). This gives the small bank the capital it needs to grow. The bank then can make more loans. But for the small bank to make money, it needs to make riskier loans, so that it can have a large enough spread on interest to make serious profits. So these small banks start shoveling money out the door to whoever has a good idea -- developers with new sprawl divisions or strip malls, sub-prime loans to those individual depositors, and other complicated financial lending instruments.

But what happens then? Well some small banks in this past decade have grown significantly due to hot money, but many of them are starting to pay the piper, because money of the loans they have made are going bust. Almost all the banks shut down by the FDIC this year are due to 'hot money' issues. And the brokered depositors are treated like any other depositor.

Though few people have heard of it, hot money — or brokered deposits, as it is also known in the industry — is one of the primary factors in the accelerating wave of failures among small and regional banks nationwide. The estimated cost to the Federal Deposit Insurance Corporation over the last 18 months is $7.7 billion, and growing.

nytimes

'Hot money' is called hot because the brokered deposits can leave the bank they're parked anytime better rates come calling. So if a banks deposits are made up of a significant percentage of brokered deposits, the culture and the operating principles of the bank change accordingly. Short-term profits over long term sustainability, the very ideas that many of us associate with community banks. Very zombie-like.

And when a bank is failing, the brokered depositors are going to know and have the added leverage of being able to move their money out (possibly precipitating a failure) as well as FDIC insurance.

I suggest that people read the NY Times article linked above. It gives a good overview of how 'hot money' is the zombie ju-ju of this economy. This has been an issue since Penn Square bank in Oklahoma City collapsed in 1982 setting off the S&L crisis. For a larger context, people need to realize that the money-market is much larger than the equities market on Wall Street. And every time there has been an attempt at nominal regulation it has been beaten back by the small and large banks lobbying efforts. And this is now a global market. Small banks are competing against banks in Europe and the global South for these dollars, though that is somewhat mitigated by capital controls in various countries, especially SE Asia after going through similar problems.

From wikipedia

Common money market instruments

   * Bankers' acceptance - A draft issued by a bank that will be accepted for payment, effectively the same as a cashier's check.

   * Certificate of deposit - A time deposit at a bank with a specific maturity date; large-denomination certificates of deposits can be sold before maturity.

   * Repurchase agreements - Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.

   * Commercial paper - Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.

   * Eurodollar deposit - Deposits made in U.S. dollars at a bank or bank branch located outside the United States.

   * Federal Agency Short-Term Securities - (in the U.S.). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.

   * Federal funds - (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.

   * Municipal notes - (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.

   * Treasury bills - Short-term debt obligations of a national government that are issued to mature in three to twelve months. For the U.S., see Treasury bills.

   * Money funds - Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.

   * Foreign Exchange Swaps - Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

The money market is where most of the actual investing goes on. And it is interesting, knowing how a lot of these shaky loans were then sold to other companies, that in turn created MBS (mortgage backed securities) or ABS (asset backed securities) which fed the development of CDOs which were then sold back to many of the players in money-markets, like municipalities, small banks, pension funds, etc. All the while, the large investment houses on Wall Street were sucking up cash at every point.

Investment houses don't like cash sitting because that is a money losing proposition in a low-inflationary environment. They like to move that cash and multiply it all along its trajectory. And like all things, this is good in moderation. But we have had a system where banks can get unlimited amounts of this 'hot money' which leads to immoderate growth in their respective local economies and now we are all paying the price.

Any serious financial regulation is going to have to address this issue.

Late last year, the F.D.I.C. proposed a new rule. Banks that rely too heavily on brokered deposits to accelerate their growth will have to pay a higher insurance premium to help cover losses if they fail. The proposed limit was 10 percent brokered deposits and a growth rate of 20 percent over four years.

Just as it did in the early 1980s, industry opposition emerged almost overnight. ....

The banks won important concessions. The regulator relaxed the part of the rule that required higher premiums if banks grew too fast with brokered deposits, allowing a growth rate of up to 40 percent over four years. And it left open a loophole that lets banks — even those considered unsound — turn to a "listing service," a source of hot money by another name. Instead of paying a broker, banks pay to subscribe to an electronic bulletin board of credit unions with money to park.

nytimes

But this will be an epic battle because many of these banks believe it is their right to zombify at their convenience. The attitude of Wall St., that we are smarter than you, that we know better than you, is an attitude that infects Main St. as well. Local bankers have an outsize influence on local politics in many parts of the country. The change we seek is going to have to come from the local level. And beyond this, the US government is beholden to these interests even moreso than they are beholden to China's interests, as the largest group of investors in Treasuries are US nationals (a group that includes community banks).

What I hope people realize is that this one activity of brokered deposits works against many of our progressive ideas about transforming this country. 'Hot money' incentivizes many of the bad practices municipalities engage regarding city growth and development. As long as there is unlimited cash available for the banks that want it, there are going to be incentives to move that capital into unsustainable projects that do not add to the productive capacity of this country. It is ultimately about valuing the short-term bursts of growth over the long-term stability of our economies, locally and regionally. And I realize that this is one part of the problem, but it is a serious structural flaw in capital-allocation, a flaw that has had serious consequences around the country. So I hope I educate a few of you about this issue, as well as, being educated in the comments. I'm sure there is an expert or two out there who will comment on the validity of some of these assertions.

As far as I can tell, a reasonable regulation would be to limit brokered deposits to some percentage of total or actual deposits in the bank, and/or tying the FDIC insurance premium to the various percentages of brokered deposits and forcing investment houses like Merrill Lynch to pay a transaction premium for moving deposits around, as well as having a non-loophole definition of what qualifies as a brokered deposit. All of these actions would cool the 'hot money' market without killing it, as well as insuring the FDIC has the resources to unwind banks once we return to a more normal system of growth/recession centered on the dynamics of the business cycle, which this recession is currently not, in my lay opinion.

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Bank of England injects £25bn more into economy

The Bank of England’s monetary policy committee (MPC) is expected to extend its programme of quantitative easing (QE) by £25 billion, though there are doubts whether it will take action beyond that. The Bank has so far committed £125 billion of QE in an attempt to boost the money supply, mainly through purchases in the markets of gilts and other assets. It has permission from the Treasury for a further £25 billion of such purchases, which analysts expect to be announced this week. Beyond this, it would have to seek new approval from the Treasury, which indemnifies the Bank against losses on the scheme.

The shadow MPC, a group of independent economists that meets under the auspices of the Institute of Economic Affairs (IEA), today calls on the Bank to maintain the base rate at 0.5% and extend QE beyond the £150 billion it currently has permission to undertake. “There was a widespread feeling among the members of the IEA’s shadow committee that QE was the only effective monetary policy instrument presently available to the authorities,” it said. “Several committee members believed that the present schedule of gilt purchases should be extended. Some members thought that an additional £100 billion to £150 billion of debt repurchases was required once the current package had run its course.”

Economists continue to debate whether QE is working, with bank lending still subdued. The policy has become of central importance to the gilt market. Traders fear that gilts — UK government bonds — will fall sharply once the Bank calls a halt to the programme. The Bank will discuss if it should extend QE next month, when it has the benefit of a new forecast for its August inflation report. It will weigh signs that the economy has stabilised against other evidence suggesting a sustained recovery is some way off.

A report to be published this week is set to show that the pace of the job market’s decline is slowing. The KPMG/REC Report on Jobs, produced by the accountancy firm in conjunction with the Recruitment and Employment Confederation, will suggest that the pace of decline in permanent and temporary staff appointments has eased — a picture consistent with recent official data showing a smaller monthly increase in unemployment following record rises in the winter.

This also chimes with the purchasing managers’ indices, particularly for the service and manufacturing sector, which continued their improving trend last month. However, official figures last week showed that “money GDP” — gross domestic product in nominal terms — was 4% lower in the first quarter compared with a year earlier. The Bank has said that one of the aims of QE is to get money GDP growing by 5% a year, in line with trend growth in the economy and the inflation target.

Analysts see little prospect of a change in interest rates from the Bank until well into next year. A survey by Ideaglobal.com, the financial research consultancy, suggests that the Bank will not begin “normalising” rates — raising them — until the third quarter of 2010.

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Gordon Brown under new pressure over public finances

Gordon Brown has come under fresh pressure over the public finances after John Hutton, the former defence secretary, said that voters expect "honesty" about the need for cuts in Government spending. Mr Brown is trying to frame the next election as a choice between "Tory cuts" and "Labour investment", despite predictions from independent economists that Labour's huge Government borrowing will mean that whoever wins the next election will have no choice but to cut spending.

Privately, some ministers are uneasy over the Prime Minister's refusal to admit spending will have to be cut by whoever wins the next election, believing it will hurt Labour's standing. Mr Hutton, who quit the Cabinet last month, said that voters realise that the growing gap between what the Government spends and what it raises in tax means that the public sector will inevitably face a squeeze. Mr Hutton said: "I think fundamentally people know their belts need to be tightened and I think the discipline and responsibility of politicians is to be clear about what they are going to prioritise - is it health, is it education, is it schools is it defence?"

He added: "There's going to be a very important debate in the next few months about that. Politicians have got to lead that debate and be clear with people." "The country expects honesty about this. They know that things are going to be tight in the next few years." "People are much more grown up than we often assume. They understand a change is coming." The current spending round ends in March 2011. Labour has not yet set out any detailed spending plans after that, but independent economists have said that significant cuts are inevitable. David Cameron, the Tory leader, has accused Mr Brown of "dishonesty" over public spending, saying the failure to publish detailed spending plans is an attempt to conceal the cuts Labour would be forced to make.

If the Government of the day chooses to protect health and education spending, the Institute for Fiscal Studies puts those cuts at around 10 per cent in other Whitehall departments. The alternative to cutting spending would be to raise more money in taxes. Sir John Major, the former Conservative prime minister, said that the country would face "very significant tax rises" if spending is not cut, perhaps as high as 5 pence added to income tax, or a 20 per cent rate of VAT.

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Alistair Darling hits at cuts and pay squeeze as finances worsen

The state of the economy is worse than at the time of April's Budget and could result a squeeze in public sector pay announced within weeks, the Chancellor has admitted. Alistair Darling also acknowledged that government spending faces "much tighter" limits as a result of the recession, in one of the most frank interviews about the state of the public finances so far. Last week the Office for National Statistics revealed the recession had begun three months earlier than had been thought, in April last year rather than July, and that the economy had slumped at its fasted pace for 50 years, down 2.4 per cent rather than previous forecast of 1.9 per cent.

Speaking on Sunday Live on Sky News, Mr Darling said: "At the time of the Budget I said the downturn would be very substantial". Asked if it was worse than he anticipated, he said: "It has been", but added that many commentators now agreed that Britain will come out of recession at the end of the year. Mr Darling also acknowledged he came within a short distance of being sacked as Chancellor. Asked if Gordon Brown wanted to replace him with Ed Balls, who remained Schools Secretary at the last reshuffle, he said: "Some conversations I never ever repeat. In politics you have to be grown up about it. I'm here now and I have a job of work to do."

Mr Darling was challenged why there were no plans for a Comprehensive Spending Review, setting out departmental budgets between 2011 and 2014. Although he confirmed that public spending was being accelerated "now" in order to help the economy, he gave one of the most explicit indications to date that it will contract significantly in the future. The Chancellor said that "it doesn't make any sense to fix in detail [the figures]. But the overall envelope will be much tighter."

Reports in The Sunday Times suggest that mandarins in some departments are expecting to have to slash budgets by up to 20 per cent. Mr Darling did not deny the claim, saying: "It's not attributed to the Treasury." He also admitted he would be likely to revise down government forecasts at the pre Budget report in the Autumn. "We will come back at the Pre Budget Report and ... we will have to make further judgements. Public sector pay could be one of the first areas to be squeezed, with announcements coming in the next "few weeks".

"Public sector pay has got to reflect prevailing conditions. We have to be fair to people in private companies. We will decide on pay policy over the next few weeks." Mr Darling was appearing ahead of a new drive to tell bankers that they must behave responsibly. He admitted he is asking the banks to do two sometimes contradictory things: strengthening their own balance sheet positions while also asking them to lend more to businesses. But he said that the government had been instrumental in stabilising their position to help them do this.

"That's why [we looked at] the behaviour of the bankers themselves, and why the regulators need to learn the lessons of what went wrong," he said. Meanwhile Sir John Major, the former Tory Prime Minister, said that government must "downsize", suggesting that growing the state further "is a route that ends in national bankruptcy." He said the government should reduce its size by a third, including cutting the numbers of ministers and civil servants. He said the recession presented Britain with a "philosophical opportunity" to reassess the role of the state.

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Poor face disaster from global warming

Most of the gains made by the world's poorest countries over the past half a century will be lost unless action is taken on climate change, Oxfam says. A report by the international aid agency says up to 375 million people may be affected by climate-related disasters by 2015. "Climate change is becoming quite rapidly the central issue to do with poverty today", Oxfam Australia's chief, Andrew Hewett, told the Herald. "That also raises deep ethical dilemmas because the people least responsible for this crisis have the least resources to deal with it, and they are also those who are on the front line."

Oxfam is publishing the report, Suffering The Science-Climate Change, People And Poverty, today before this week's meeting of world leaders at the Group of Eight summit in Italy, where climate change and food security will be high on the agenda. On the side of the G8 meeting there will also be a forum of leaders and ministers from the biggest polluting world economies, which the Prime Minister, Kevin Rudd, and Climate Change Minister, Penny Wong, will attend.

A key issue at both meetings will be whether the US President, Barack Obama, publicly embraces the scientific goal of keeping the world's temperature from rising above 2 degrees Celsius in order to avoid dangerous climate change. Britain's Prime Minister, Gordon Brown, and European leaders have been urging the US to embrace the goal, and Reuters has reported that the 2-degree target has been included in the draft communique. If Mr Obama supports the scientific goal he will raise expectations that the United Nations global climate talks in Copenhagen in December will be able to achieve an ambitious outcome.

Including the 2-degree goal in the G8 communique also puts pressure on Japan, Canada and Russia to agree to tougher action to cut greenhouse gas emissions. The Oxfam report stresses the importance of the scientific goal, arguing that even a 2-degree temperature rise will have serious consequences for people living in poverty. With advancing climate change, several big cities dependent on the Himalayan and Andes glaciers will face crippling water shortages within decades, the report says.

The two most important world food crops, rice and maize, will also be reduced even under mild climate change. Hunger caused by climate change may be the defining human tragedy of this century, the report argues, and if global warming is allowed to proceed unchecked the true cost "will not be measured in dollars but in millions or billions of lives". Oxfam argues that developing countries, especially poor ones, will need at least $US150 billion ($188 billion) a year to cope with climate change and shift to greener energy.

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