Cab stand at Madison Square, New York City
Ilargi: A happy new year for all of you from us at the Automatic Earth. May you spend every minute of it in the best of health and the greatest of company. We strongly recommend you pay increased atttention to both; chances are you're going to need them more than ever this year. Worth more than pieces of gold, as the man says.
Stoneleigh opens 2010 with a reflection on patterns that emerge throughout the living world, including the way we organize our economic systems, and how they organize us in return.
Fractal Adaptive Cycles in Natural and Human Systems
Adaptive cycles are the foundation of both natural ecological and human socio-economic systems, and have been investigated independently from very different perspectives by ecologists and financial analysts who have almost certainly never heard of each others' work. It is interesting then to look at the strong correspondence of the self-similar hierarchical patterns, best described as fractals, which emerge from both fields. This form of organization seems to be a fundamental dynamic in many areas.
The bewildering, entrancing, unpredictable nature of nature and people, the richness, diversity and changeability of life come from that evolutionary dance generated by cycles of growth, collapse, reorganization, renewal and re-establishment. We call that the adaptive cycle. Holling, 2009
Holling, Panarchy and Resilience
Arguably the most significant thinker in the field of ecological cycles has been Buzz Holling, who refers to the conceptual model he derived from the study of forest ecosystems as Panarchy. Holling observed that ecosystems developed in adaptive cycles of exploitation, conservation, release and reorganization which could be described in three dimensions - ecological 'wealth', connectedness and resilience. These cycles provide a framework for the opposing forces of growth and stability versus change and variety.
In an adaptive cycle, early growth is rapid as individuals of many species arrive in a newly opened space and seek to exploit a plethora of vacant ecological niches. Genetic diversity and biomass, both living and dead, increase quickly in this expansion phase. Ecological connections are initially simple and sparse, but over time many interconnections and mutual dependencies develop.
The system therefore increases in both 'wealth' and connectedness, as flows of energy and materials become larger and more complex. Biological 'wealth' confers the potential for novelty, allowing the system to adapt in disparate directions as circumstances warrant. Connectedness permits increasing stability, through the development of negative feedback loops, which help to regulate conditions conducive to life.
There are about three kinds of scientists - the consolidator, the technical expert, and the artist. Consolidators accumulate and solidify advances and are deeply skeptical of ill formed and initial, hesitant steps. That can have a great value at stages in a scientific cycle when rigorous efforts to establish the strength and value of an idea is central. Technical experts assess the methods of investigation. Both assume they search for the certainty of understanding.
In contrast, I love the initial hesitant steps of the "artist scientist" and like to see clusters of them. That is the kind of thing needed at the beginning of a cycle of scientific enquiry or even just before that. Such nascent, partially stumbling ideas, are the largely hidden source for the engine that eventually generates change in science. I love the nascent ideas, the sudden explosion of a new idea, the connections of the new idea with others. I love the development and testing of the idea till it gets to the point it is convincing, or is rejected. That needs persistence to the level of stubbornness and I eagerly invest in that persistence. Holling, 2009
As time passes, rapid growth gives way to conservation. Inter-dependencies become highly specialized and self-regulation becomes fine-tuned and sophisticated. Efficiency is maximized as niches are fully occupied, and flows of energy and nutrients are tightly controlled by the existing biota. This represents the end of the growth phase.
Relatively few opportunities are left for newcomers or novel strategies, hence diversity stabilizes or declines. The system is 'rich', but becomes more rigid, and therefore less resilient in the face of potential shocks, which can propagate rapidly through a highly inter-connected system with smaller margins for error than it had in its generalist phase. An increasingly brittle ecosystem becomes, in Holling's words, "an accident waiting to happen".
When something does push the ecosystem outside of the boundaries it can tolerate, the long growth phase can morph into a rapid and chaotic release and reorganization phase, where nutrients and energy stores previously tied up can suddenly be liberated. This can be associated with a considerable loss of complexity, but also with much greater potential for generalist strategies and for novelty.
- During the growth phase the system finds an abundance of resources available. Expansion and exploration of new opportunities are key concepts within this stage. “When new ecological spaces open up – due, for instance, to forest fires, or retreating glaciers, or many other things- resources needed for other species to grow are made available. There’s more light reaching the soil surface when large trees are toppled, or burned to the ground, for example.”
- “The "r" phase is transitory, and as the system matures, it is replaced by the K phase. Eventually slower growing, long lived species or entities enter the system. Resources become less widely available as they become “locked up”… The K phase is sometimes called the conservation phase, because energy acquired goes into maintaining or conserving existing structure, rather than building new structure. In this phase, a few dominant species or companies or countries … have acquired many of the resources and are controlling the way they can be used.”
- “Often systems rapidly pass into a phase called omega. This is also referred to as the release (or creative destruction) phase because structure, relationships, capital or complexity accumulated during the r and K phases is released (often in a dramatic or abrupt fashion). … Plants may die … or a company may go bankrupt, releasing workers and decommissioning factories or offices.”
- “The fourth, or alpha phase, is a period of reorganization, in which some of the entities previously released begin to re-structure but not necessarily as they were before. This phase can mark the beginning of another trip through an adaptive cycle … Many new entities may enter the system, and innovation becomes more probable.”
However, such adaptive cycles do not exist in isolation. Local ecosystem cycles are embedded in larger and slower-moving regional cycles operating over years and decades, which are in turn part of global climate and elemental cycles (carbon, nitrogen, phosphorus etc) that may unfold over centuries or millennia. These larger cycles can act as stabilizing factors by adding a 'memory effect', or wealth reservoir, enabling rapid regeneration following a localized setback, but only if the larger cycle is not in its own contraction and reorganization phase. In addition to being part of larger cycles, dynamic ecosystems are also composed of smaller and faster-moving cycles of growth and decay, operating on much shorter time horizons. This nested set of self-similar structures allows for both persistence and innovation.
Where higher and lower order cycles are very tightly coupled, they may synchronize, becoming trapped in a extended growth phase at many scales at once, thereby risking synchronous collapse. This need not be triggered at a large-scale level, but can begin anywhere in a set of nested adaptive cycles and proceed both upwards and downwards. A destabilizing event arising from below, for instance a disease outbreak leading to widespread morbidity and further adverse consequences, is called a 'revolt'.
A synchronous collapse, which can take the form of a "pancaking implosion", to use Holling's term, can lead to a poverty trap, or persistent maladaptive state characterized by low 'wealth' and connectivity, which is very much more difficult to recover from than a localized reversal would have been.
By way of illustration, the Canadian province of British Columbia is currently facing a confluence of circumstances that pose a significant large-scale ecological threat. A long-standing policy of fire-suppression, in a hitherto naturally fire-controlled ecosystem, has led to a thick understory of growth, which has in turn caused significant stress to trees forced to compete for water and nutrients in an area becoming warmer and drier. Trees under stress have much lower resistance to pine beetle infestation, with the result that a pine beetle population explosion is killing huge tracts of forest despite all efforts to contain the outbreak.
This adds to the combustible material on the forest floor and greatly increases the risk of widespread conflagration. The much smaller self-limiting fires typical of the province would have opened up areas for new growth, killed insect pests and released nutrients for regeneration, and in fact are required by some tree species in order to open up seed pods for reproduction. In contrast, very large and intense fires, fueled by a tremendous excess of flammable detritus, can comprehensively denude enormous tracts of land.
This can remove the biological reservoir of potential repopulating species as well as lead to enough soil erosion to inhibit regrowth of the forest ecosystem. An interlocking series of adaptive cycles has been synchronized through being locked into an extended growth phase and is therefore much more vulnerable to a catastrophic event that could become a lasting poverty trap.
When collapse occurs it can be a natural part of the pattern of adaptation and learning. That is what happens in forests when they burn or are attacked by natural enemies. Recovery typically replaces the old with a similar but new pattern that is similar because of the memory reserved in seeds and vegetation of the understory.
But when the collapse occurs as a consequence of long effort to freeze the system into one paradigm of development and management, then it might involve collapse of a level of the panarchy, which in turn threatens other levels. The collapse of ancient societies has this character- the top religious and political controls can collapse, triggering the gradual collapse of institutions till the family is left as the sole source of survival. It leads to a "poverty trap." Holling, 2009
Much of Holling's work has focused on the crucial role of resilience in both natural and human systems, and the Resilience Alliance has been the result:
We define resilience, formally, as the capacity of a system to absorb disturbance and reorganize while undergoing change so as to still retain essentially the same function, structure and feedbacks - and therefore the same identity.
Resilience arises from a redundancy that has the appearance of inefficiency and a lack of critical structural dependency on specialized hierarchy, neither of which conditions are likely to be met at the peak of the growth phase of an adaptive cycle. For these to be achieved from this point at least a partial, or localized, collapse to a simpler level of organization would have to occur. There can potentially be a fine line between a retreat from rigidity to this level of resilience and a 'poverty trap', where a collapse has proceeded so far and so fast that the system has been stripped of the wealth (biological or otherwise) that it would need to rebuild. Where adaptive cycles have become synchronized, so that the likelihood of deep collapse is increased, striking a balance of resilience would be far more difficult.
A resilient world would promote biological, landscape, social and economic diversity. Diversity is a major source of future options and of a system's capacity to respond to change.
- A resilient world would embrace and work with natural ecological cycles. A forest that is never allowed to burn loses its fire-resistant species and becomes very vulnerable to fire.
- A resilient world consists of modular components. When over-connected, shocks are rapidly transmitted through the system - as a forest connected by logging roads can allow a wild fire to spread wider than it would otherwise.
- A resilient world possesses tight feedbacks. Feedbacks allow us to detect thresholds before we cross them. Globalization is leading to delayed feedbacks that were once tighter. For example, people of the developed world receive weak feedback signals about the consequences of their consumption.
- A resilient world promotes trust, well developed social networks and leadership. Individually, these attributes contribute to what is generally termed "social capital," but they need to act in concert to effect adaptability - the capacity to respond to change and disturbance.
- A resilient world places an emphasis on learning, experimentation, locally developed rules, and embracing change. When rigid connections and behaviors are broken, new opportunities open up and new resources are made available for growth.
- A resilient world has institutions that include "redundancy" in their governance structures and a mix of common and private property with overlapping access rights. Redundancy in institutions increases the diversity of responses and the flexibility of a system. Because access and property rights lie at the heart of many resource-use tragedies, overlapping rights and a mix of common and private property rights can enhance the resilience of linked social-ecological systems.
- A resilient world would consider all nature's un-priced services – such as carbon storage, water filtration and so on - in development proposals and assessments. These services are often the ones that change in a regime shift – and are often only recognized and appreciated when they are lost.
This will be a very tall order in a panarchic future.
Prechter, Elliottwaves and Socionomics
Bob Prechter has also spent decades studying the structure of nested cycles, but in his case in financial markets, carrying on the work of RN Elliott, who established the field in the 1930s. Elliott painstakingly documented motive (impulse) and corrective patterns which unfold at all degrees of trend simultaneously - from small moves completing in minutes to larger cycles playing out over months, years, decades and longer. Elliott noted that motive waves in the direction of the one larger trend occur in fives, while corrective waves counter to the one larger trend form threes or multiples thereof.
Prechter explains that this is the minimum requirement for an adaptive cycle capable of both fluctuation and progress, and therefore the most efficient form. Each move itself is composed of the same patterns, while each also forms a component part of larger structures. (Motive waves are labeled with numbers, while corrective waves are labeled with letters.)
As opposed to self-identical fractals, whose parts are precisely the same as the whole, and indefinite fractals, which are self-similar only in that they are similarly irregular at all scales, a robust fractal is one of intermediate specificity. Though variable, its component forms, within a certain defined latitude, are replicas of the larger forms. Prechter, 1999, p17
Bob Prechter's socionomics model combines Elliott's observed fractal patterns with an understanding of human herding behaviour, comprising a comprehensive challenge to prevailing notions such as the Efficient Market Hypothesis by reversing causation and recognizing the role of emotional/irrational behaviour as the prime market driver. While the real economy demonstrates negative feedback loops, finance is thoroughly grounded in positive feedback.
Socionomics provides a model of collective mood swings which permits collective human behaviour prediction in finance, the real economy and beyond. Consensus takes time to build, so that the more extreme the sentiment, the closer one is to a trend change. Collectively optimistic people engage in one range of behaviours over different timescales - typically buy stocks, borrow funds to build businesses, employ others in the expectation of profit, vote for incumbents whom they credit with stability, engage in cheerful expressions of popular culture and behave in an increasingly inclusive manner in recognition of common humanity.
Collectively pessimistic people become increasingly risk averse and suspicious of others, in whom they look for differences rather than similarities. Both optimistic and pessimistic behaviours, particularly in their extreme forms, can create self-fulfilling prophecies for varying periods of time, until perception substantially overshoots reality and the trends it creates can no longer be sustained. The manic trend of recent years has led to an unsustainable debt burden of unprecedented scope and complexity. It also led to an unprecedented degree of global economic and financial integration dependent on hierarchical specialization, comparative advantage and just-in-time delivery that are clear examples of rigidity creating a brittle system.
Like Holling's panarchy, Prechter's nested socionomic cycles either reinforce or counter each other depending on the direction of cycles larger and smaller than the one under consideration. Where cycles at several degrees of trend are moving in the same direction, the move will be extreme - either a mania to the upside or a crash to the downside. The largest mania ever known topped in the year 2000, and we have been in bear market territory since then (more obviously in real terms).
We are now approaching a synchronized move in the opposite direction as the rally of recent months peters out in the face of the larger downtrend. The consequences of this will be considerable, but we are still quite near the beginning of the large-scale and complex downward pattern the model predicts will unfold over the next several decades. We can expect many deleveraging cascades and many intervening rallies, some larger than we have seen so far.
It is inevitable that the complex web of debt instruments and inter-dependencies that humanity invented to prolong its growth phase (to use Holling's terminology) by stealing from the future will be a prime focus for a sharp reversal, as we have already reached the point where additional debt provides less than no benefit. Socionomics tells us that the trust and complacency as to systemic risk that allowed this debt structure to develop will be primary casualties of a synchronized move to the downside, being both cause and effect in a powerful positive feedback loop.
Tainter, Complexity and Peer Polities
Joseph Tainter's work complements that of Holling and Prechter, providing a framework of diminishing marginal returns to complexity which encompasses ecosystems, individual societies and competitive peer polities. As complexity increases, it eventually becomes a liability, as we can see with Holling's description of rigidity reducing the resilience of ecosystems and Prechter's many writings on the debt complexity of manias and the systemic risk it engenders.
As with diminishing marginal productivity of debt, past a certain point further investments in complex solutions to increasingly complex problems has a negative return. Tainter explains, however, that where there is not a single political structure, but instead competitive peer polities, these entities become trapped in a competitive spiral where investment in organizational complexity must be maintained regardless of cost, as the alternative is domination by another member of the cluster at the same level of complexity, rather than collapse to a simpler system. The counter-productive actions of states are legitimized to the citizenry by the fact that each member of the cluster is engaging in the same behaviour. Collapse, which requires a power vacuum, is not possible unless the whole cluster collapses at once at the point of economic exhaustion.
Peer polity systems tend to evolve toward greater complexity in lockstep fashion as, driven by competition, each partner imitates new organizational, technological, and military features developed by its competitors. The marginal return on such developments declines, as each new military breakthrough is met by some counter-measure, and so brings no increased advantage or security on a lasting basis.. A society trapped in a competitive peer polity system must invest more and more for no increased return, and is thereby economically weakened. And yet the option of withdrawal or collapse does not exist.....Peer polity competition drives increased complexity and resource consumption regardless of cost, human or ecological. Tainter, 1988, p214
Tainter observes that the peer polity nature of the modern world creates a more apt comparison with the rapid collapse of the ancient Maya than with the slow decline of Rome. To use Holling's terminology, we have seen a panarchy of nested cycles synchronize, with the effect of artificially extending the growth phase for all simultaneously. The evidence for this is abundantly available in terms of the many limits to growth we are approaching or have reached, most notably the high EROEI energy required to maintain complexity. The significant risk is therefore of deep collapse over a relatively short period of time (although this would still likely be decades at least).
Collapse, if and when it comes again, will this time be global. No longer can any individual nation collapse. World civilization will disintegrate as a whole. Competitors who evolve as peers collapse in like manner. Tainter, 1988, p214
- LH Gunderson and CS Holling (2001). Panarchy: Understanding Transformations in Human and Natural Systems.
- RR Prechter (1999). The Wave Principle of Human Social Behaviour and the New Science of Socionomics.
- RR Prechter (2002). Conquer the Crash.
- RR Prechter (2003). Pioneering Studies in Socionomics.
- JA Tainter (1988). The Collapse of Complex Societies.
Ilargi: Our New Year’s Fund is still up and running and ready for your kind donations. No need to be so shy, there's a whole new year out there in front of you.
Who Is Responsible For The Non-Stop Market Rally Since March?
by Charles Biderman, CEO, TrimTabs
Are Federal Reserve and U.S. Government Rigging Stock Market? We Have No Evidence They Are, but They Could Be. We Do Not Know Source of Money That Pushed Market Cap Up $6+ Trillion since Mid-March.
The most positive economic development in 2009 was the stock market rally. Since the middle of March, the market cap of all U.S. stocks has soared more than $6 trillion. The “wealth effect” of rising stock prices has soothed the nerves and boosted the net worth of the half of Americans who own stock.
We cannot identify the source of the new money that pushed stock prices up so far so fast. For the most part, the money did not from the traditional players that provided money in the past:
- Companies. Corporate America has been a huge net seller. The float of shares has ballooned $133 billion since the start of April.
- Retail investor funds. Retail investors have hardly bought any U.S. equities. Bond funds, yes. U.S equity funds, no. U.S. equity funds and ETFs have received just $17 billion since the start of April. Over that same time frame bond mutual funds and ETFs received $351 billion.
- Retail investor direct. We doubt retail investors were big direct purchases of equities. Market volatility in this decade has been the highest since the 1930s, and we no evidence retail investors were piling into individual stocks. Also, retail investor sentiment has been mostly neutral since the rally began.
- Foreign investors. Foreign investors have provided some buying power, purchasing $109 billion in U.S. stocks from April through October. But we suspect foreign purchases slowed in November and December because the U.S. dollar was weakening.
- Hedge funds. We have no way to track in real time what hedge funds do, and they may well have shifted some assets into U.S. equities. But we doubt their buying power was enormous because they posted an outflow of $12 billion from April through November.
- Pension funds. All the anecdotal evidence we have indicates that pension funds have not been making a huge asset allocation shift and have not moved more than about $100 billion from bonds and cash into U.S. equities since the rally began.
If the money to boost stock prices did not come from the traditional players, it had to have come from somewhere else.
We do not know where all the money has come from. What we do know is that the U.S. government has spent hundreds of billions of dollars to support the auto industry, the housing market, and the banks and brokers. Why not support the stock market as well?
As far as we know, it is not illegal for the Federal Reserve or the U.S. Treasury to buy S&P 500 futures. Moreover, several officials have suggested the government should support stock prices. For example, former Fed board member Robert Heller opined in the Wall Street Journal in 1989, “Instead of flooding the entire economy with liquidity, and thereby increasing the danger of inflation, the Fed could support the stock market directly by buying market averages in the futures market, thereby stabilizing the market as a whole.”
In a Financial Times article in 2002, an unidentified Fed official was quoted as acknowledging that policymakers had considered buying U.S. equities directly, not just futures. The official mentioned that the Fed could “theoretically buy anything to pump money into the system.” In an article in the Daily Telegraph in 2006, former Clinton administration official George Stephanopoulos mentioned the existence of “an informal agreement among the major banks to come in and start to buy stock if there appears to be a problem.”
Think back to mid-March 2009. Nothing positive was happening, and investor sentiment was horrible. The Fed, the Treasury, and Wall Street were all trying to figure out how to prevent the financial system from collapsing. The Fed was willing to print whatever amount of money it took to bail out the system.
What if Ben Bernanke, Timothy Geithner, and the head of one or more Wall Street firms decided that creating a stock market rally was the only way to rescue the economy? After all, after-tax income was down more than 10% y-o-y during Q1 2009, and the trillions the government committed or spent to prop up all sorts of entities was not working.
One way to manipulate the stock market would be for the Fed or the Treasury to buy $20 billion, plus or minus, of S&P 500 stock futures each month for a year. Depending on margin levels, $20 billion per month would translate into at least $100 billion in notional buying power. Given the hugely oversold market early in March, not only would a new $100 billion per month of buying power have stopped stock prices from plunging, but it would have encouraged huge amounts of sideline cash to flow into equities to absorb the $300 billion in newly printed shares that have been sold since the start of April.
This type of intervention could explain some of the unusual market action in recent months, with stock prices grinding higher on low volume even as companies sold huge amounts of new shares and retail investors stayed on the sidelines. For example, Tyler Durden of ZeroHedge has pointed out that virtually all of the market’s upside since mid-September has come from after-hours S&P 500 futures activity.
If we were involved in a scheme to manipulate the stock market, we would want to keep it in place until after the “wealth effect” put a floor under the economy of, say, three quarters of positive GDP growth. Assuming the economy were performing better, then ending the support for stock prices would be justified because a stock market decline would not be so painful.
We want to emphasize that we have no evidence that the Fed or the Treasury are throwing money into the stock market, either directly or indirectly. But if they are not pumping up stock prices, then who else is?
Ilargi: You can vote at Mandel's site, just click the article title, but some good reasoned choices would not harm our own comment section either.
Economic Statistic of the Decade Award:Finalists
by Mike Mandel
Economic statistics don’t get enough recognition for all of their hard work. So, I’ve decided to offer an “Economic Statistic of the Decade” Award. The three criteria are simple. First, we want to reward the economic statistic that best reflects the decade (both the good and the bad). Second, we want to recognize the economic statistic that turned in a surprising performance–that is, back in 2000, if someone had shown you a graph of the statistic over the next ten years, you would have said “no way”. Third, we want to reward economic statistics that are reliable and accurate representations of the actual economy.
In the 1990s, for example, the Economic Statistic of the Decade Award would have gone to U.S. productivity growth. The runner-ups would have been Chinese economic growth, followed by global tech spending.
What about this decade? Here are the four finalists (chosen by me):
- Housing prices
- Global trade
- Chinese growth
- U.S. household borrowing
Here’s a bit about each of the finalists:
1) The boom and bust in housing prices clearly epitomizes the decade. What’s more, in 2000 nobody in their right mind would have predicted that the boom lasted as long as it did. Downside: The gyrations in the housing market may be a symptom of deeper problems, much like a fever is a symptom rather than a disease in its own right (The chart below is drawn from the Case-Shiller price indexes)
2) Globalization has been one of the main themes of this decade–and nothing illustrates globalization more than the rise in exports as a share of global GDP. In 1999, global exports were about 22.7% of global GDP, as measured by the International Monetary Fund. By 2008, that number was 32. 3% before plummeting in 2009. Downside: There may be systematic double-counting, as companies break up production into smaller and smaller pieces.
3) Chinese economic growth would have been one of the runner-ups for the Economic Statistics of the Decade for the 1990s. Chinese economy growth averaged an astounding 10% peryear in that decade, and looks like it’s going to get to the same level again in this decade. Downside: No one is really sure whether to trust the Chinese economic statistics or not.
4) Finally, we come to U.S. household borrowing, which probably is the clearest reflection of the financial crisis. In this decade the U.S. household sector amped up its borrowing from $500 billion in 1999 to $1.2 trillion in 2006, before dramatically cutting debt in 2009. Downside: This number from the Federal Reserve includes domestic hedge funds and nonprofit organizations, making it a bit tough to interpret.
I will present the winner of the award in a few days. If you want to vote for one of these, or propose an alternative, go for it!
Is The US Government Misrepresenting Unemployment By 32%?
by Tyler Durden
There is an old saying, "when in doubt follow the money." These days investors have lots of doubt about pretty much everything (if not so much money). And with data from the government increasingly bearing the Quality Control stamp of approval of the Beijing Communist Party, there is much doubt in store courtesy of an administration which will stop at nothing in its competition with China as to who can blow the biggest asset bubble the fastest, data integrity be damned.
Undoubtedly, of all government released data, the most important is, and continues to be, anything relating to unemployment. This is precisely where the government's propaganda armada is focused. Yet in matters of (un)employment, the ultimate authority is, luckily, the Treasury, and not the Fed. "Luckily," because when it comes to making money "difficult to follow" Tim Geithner's office still has much to learn.
Which is why when we looked at the Daily Treasury Statement data we were very surprised: because it indicates that the government could be underrepresenting employment data by up to 32%!
The suddenly very prominent topic of Unemployment Insurance, whether it pertains to Initial Claims or to Emergency Unemployment, has one very useful characteristic: it is based on "money", specifically money outflows from the US treasury which goes to fund the weekly "paychecks" of those that have not been in the workforce for well over a year. And as pointed out earlier, money can be followed. The US Treasury presents a daily in and outflow of all money sources in the Daily Treasury Statement prepared by the Financial Management Service. And in the plethora of data presented here, probably the most relevant and useful data series is the Withdrawals quantified in the form of Unemployment Insurance Benefits.
Compiling the monthly data of Treasury Disbursements for Unemployment Insurance Benefits and then superimposing it with the total number of people receiving Insurance Benefits as disclosed by the Department of Labor is a useful exercise, as the two series have historically correlated with an R2 of well over 0.90. Below is an indexed comparison of UIB outlays and Unemployment Insurance Receivers for Fiscal 2007.
Surely this is logical: the more unemployed collecting benefits from the government, the more the outlays.
Yet what struck us is the when this chart is presented from 2007 until today. Something unusual emerges. An absolute chart of the money spent by the government superimposed with the total insured unemployed is presented below:
Yet the best way to see what this chart indicates is on an indexed basis with a September 2007 baseline.
What becomes obvious is that a correlation which used to be almost 1.000 has diverged massively, and now the relative outlays surpass what the government highlights are the number of people actually collecting benefits by 32%! This implies two things: either the average unemployment monthly paycheck has surged, which is not the case, or there is some gray unemployment area which is not disclosed by the government, and which accounts for a shadow unemployed insurance economy. Because while the DOL indicates there are about 9.5 million total unemployed, for the correlation to return to its near 1.0 trendline the number of unemployed on benefits has to be 14 million.
At least this is what the actual cash outlays by the Treasury suggest: the government spent a record $14.7 billion on Unemployment Insurance Benefits as of December 30, a 24% jump sequentially from the $11.8 billion in November. Yet the DOL has disclosed a mere 1.7% increase in those to whom insurance benefits are paid: from 9.4 million to just under 9.6 million.
To put the $14.7 billion number in perspective, in December the Federal Government paid a total of $14 billion ($700 million less) in Federal Salaries! A cynic could be temped to say that effectively the number of people employed by the government is double what is disclosed. A yet bigger cynic could claim that America is now the biggest socialist state in the world. Both cynics would not necessarily be wrong.
And some more perspective: in calendar 2009 the government has paid $140 billion in Unemployment Insurance Benefits. This is yet another economic stimulus that nobody in the administration discusses, yet which undoubtedly has the biggest impact on the economy, as all those millions unemployed can moderate their pain courtesy of a passable weekly check from the government which should just about cover the rent and beer.
Which is why more than anything, Obama is dead set on extending insurance benefit payments in perpetuity: because if the 10 million official and 14 million unofficial people who are on benefits (not to mention the tens of millions of unemployed unlucky enough to even get their weekly allowance from Uncle Sam) start thinking about their true predicament and their real "employability", then a landslide loss by this administration at the mid-term elections will actually be an upside surprise to what it can objectively expect.
Hedge funds bet on deep trouble for Japan
Some hedge funds are starting to wager on painful times ahead for Japan, the world's second-largest economy. These investors, including some who made successful bets against risky mortgages and financial companies in recent years, anticipate trouble for Japan's financial system. Their concern: Government borrowing continues to climb while demand for the nation's debt could taper off.
A collapse of the Japanese government-bond market "is going to happen; it's a question of when," said Kyle Bass, head of Hayman Advisors LP, a Dallas hedge fund, who has placed wagers on that outcome. He and others, such as David Einhorn's Greenlight Capital Inc. and a fund run by Daniel Arbess of Perella Weinberg Partners LP, have been buying a variety of investments that could pay off if the Japanese bond market crumbles.
Betting against the debt of various nations such as Greece and Ireland has proved a popular move during the past several months as worries have mounted over deteriorating government finances in the aftermath of the financial crisis. But a selloff in Japan's bonds would be much more worrisome than woes in some other countries, because of the size of Japan's bond market, 694.3 trillion yen, or about $7.543 trillion, and the role Japan plays in the global economy.
"In Japan, the mist has subsided and you see this huge mountain of debt," said Tom Byrne, a sovereign-credit analyst for Asia for Moody's Investors Service. That has raised concerns among some that "this could blow," although Mr. Byrne doesn't believe that will happen. A spokesman for Japan's Ministry of Finance declined to comment.
Not everyone is worried. For starters, the wager against the country's debt has a long and unprofitable history, saddling investors with big losses. And even those with deep convictions about Japan's troubles are hedging themselves. Mr. Bass has placed only a small portion of his $650 million fund in bearish Japanese bond investments. Despite an increasing debt burden and long-standing predictions that demand for government bonds would flag, the market has held up. The biggest buyers remain domestic investors that hold almost all of the nation's debt, such as Japanese banks, pension funds and insurance companies.
That has kept yields, which move in the opposite direction of prices, low. The yield on Japan's 10-year government bond hasn't gone above 2% in more than a decade. The presence of domestic, rather than foreign, investors also reduces the possibility of a mass exit from the market. Moreover, Japan has been plagued by bouts of deflation-falling consumer prices since the late 1990s. In November, consumer prices fell for the ninth month in a row. If that persists, bonds may continue to have allure, because even slender yields can look good amid deflation.
Even some who believe yields will rise don't expect the big increase envisioned by the hedge-fund pessimists. "I just don't think it's the blowout trade some funds think it is," said George Papamarkakis of North Asset Management LLP, a London hedge fund.
But bears maintain there are reasons to bet against Japan. They note that government debt as a percentage of gross domestic product is expected to hit 219% in 2009, up from 120% in 1998, according to the International Monetary Fund. By way of comparison, debt will total 85% of the U.S.'s GDP, and 69% of the U.K.'s, the IMF said. Even net government debt, which subtracts government assets, is high in Japan; the IMF puts it at 105% of GDP in 2009, compared with 58% for the U.S.
Some predict that as Japan ages, more people retire and savings rates dip, some purchasers will start pulling back on buying or even turn into sellers. Japan's public pension fund, the world's largest, has said it could become a net seller of holdings in 2010. About three-quarters of the fund's holdings have been in Japanese bonds. "The biggest buyer is now a seller. That's the biggest difference today," said Mr. Bass of Hayman Advisors. To attract buyers, particularly from overseas, yields will have to rise significantly, the bears assert, making it painful for Japan to service its debt.
The election of new government leadership in August also has ramped up anxieties of investors, who fear less-experienced officials will spend too freely in an effort to put money in the hands of ordinary Japanese. On Wednesday, the government unveiled a plan to try to spur the economy and cut unemployment. Japan's government recently stopped short of setting a firm limit on new debt sales in the next fiscal year, a sign for bears that the country isn't committed to fiscal discipline.
Some investors burned in the past now find the trade hard to ignore. Back in 1995, David Roche, head of investment consultancy Independent Strategy, predicted that Japanese yields would rocket higher. He went so far as to call the country's debt "junk bonds in drag." That turned out to be "dead wrong," he acknowledged this year, because Japanese investors kept on depositing their savings in banks. The banks funneled the savings, together with cheap money from the central bank, back into government bonds, keeping prices buoyant and yields low.
But that arithmetic can't be repeated now, Mr. Roche wrote in a recent report. Although Japan's stock of savings remains large, the savings rate has dropped below 3%, from more than 10% in the 1990s. Traders are betting against Japan's debt in myriad ways. Some bearish traders are entering into option contracts betting on "forward rates," or the direction of Japanese yields. These options are among the most heavily traded of the commonly used bearish tools, so some beginners to the game are embracing them. The downside is investors can find themselves exposed to big losses if yields fall further.
Others buy credit-default swaps, derivative contracts that serve as insurance to protect against a default of Japan's debt. The cost to insure $10 million of Japanese bonds is about $70,000 a year for five years. That price has climbed from less than $50,000 since October. Still others are buying more exotic instruments, such as "CMS caps," also called constant-maturity-swap caps, and "swaptions." These interest-rate options reward a buyer if Japanese rates climb over the next few years, but limit downside because there is only a one-time upfront payment.
Mr. Bass has purchased protection on about $12 billion of Japanese bonds, according to a person close to his firm, a move that is costing him about $6 million, a skimpy price because most investors still doubt the trade will succeed. If 10-year yields, currently at 1.3%, rise to 3% or so, Mr. Bass won't make that much; but if they hit 4%, he would make about $125 million on his $6 million investment. He will make at least $125 million for each subsequent percentage-point rise, according to people close to the firm.
Still, such bets are on the rise. Traders said they can see increased interest in derivatives that would pay handsomely in extreme outcomes, such as if interest rates on Japanese government bonds multiplied several times, or if the yen lost a quarter or more of its value.
Harsh lessons we may need to learn again
by Joseph Stiglitz
The best that can be said for 2009 is that it could have been worse, that we pulled back from the precipice on which we seemed to be perched in late 2008, and that 2010 will almost surely be better for most countries around the world. The world has also learned some valuable lessons, though at great cost both to current and future prosperity - costs that were unnecessarily high given that we should already have learned them.
The first lesson is that markets are not self-correcting. Indeed, without adequate regulation, they are prone to excess. In 2009, we again saw why Adam Smith's invisible hand often appeared invisible: it is not there. The bankers' pursuit of self-interest (greed) did not lead to the well-being of society; it did not even serve their shareholders and bondholders well. It certainly did not serve homeowners who are losing their homes, workers who have lost their jobs, retirees who have seen their retirement funds vanish, or taxpayers who paid hundreds of billions of dollars to bail out the banks.
Under the threat of a collapse of the entire system, the safety net - intended to help unfortunate individuals meet the exigencies of life - was generously extended to commercial banks, then to investment banks, insurance firms, auto companies, even car-loan companies. Never has so much money been transferred from so many to so few.
We are accustomed to thinking of government transferring money from the well off to the poor. Here it was the poor and average transferring money to the rich. Already heavily burdened taxpayers saw their money - intended to help banks lend so that the economy could be revived - go to pay outsized bonuses and dividends. Dividends are supposed to be a share of profits; here it was simply a share of government largesse.
The justification was that bailing out the banks, however messily, would enable a resumption of lending. That has not happened. All that happened was that average taxpayers gave money to the very institutions that had been gouging them for years - through predatory lending, usurious credit-card interest rates, and non-transparent fees.
The bailout exposed deep hypocrisy all around. Those who had preached fiscal restraint when it came to small welfare programs for the poor now clamored for the world's largest welfare program. Those who had argued for free market's virtue of "transparency" ended up creating financial systems so opaque that banks could not make sense of their own balance sheets. And then the government, too, was induced to engage in decreasingly transparent forms of bailout to cover up its largesse to the banks. Those who had argued for "accountability" and "responsibility" now sought debt forgiveness for the financial sector.
The second important lesson involves understanding why markets often do not work the way they are meant to. There are many reasons for market failures. In this case, too-big-to-fail financial institutions had perverse incentives: if they gambled and succeeded, they walked off with the profits; if they lost, the taxpayer would pay. Moreover, when information is imperfect, markets often do not work well - and information imperfections are central in finance. Externalities are pervasive: the failure of one bank imposed costs on others, and failures in the financial system imposed costs on taxpayers and workers all over the world.
The third lesson is that Keynesian policies do work. Countries, like Australia, that implemented large, well-designed stimulus programs early emerged from the crisis faster. Other countries succumbed to the old orthodoxy pushed by the financial wizards who got us into this mess in the first place.
Whenever an economy goes into recession, deficits appear, as tax revenues fall faster than expenditures. The old orthodoxy held that one had to cut the deficit - raise taxes or cut expenditures - to "restore confidence." But those policies almost always reduced aggregate demand, pushed the economy into a deeper slump, and further undermined confidence - most recently when the International Monetary Fund insisted on them in East Asia in the 1990's.
The fourth lesson is that there is more to monetary policy than just fighting inflation. Excessive focus on inflation meant that some central banks ignored what was happening to their financial markets. The costs of mild inflation are miniscule compared to the costs imposed on economies when central banks allow asset bubbles to grow unchecked.
The fifth lesson is that not all innovation leads to a more efficient and productive economy - let alone a better society. Private incentives matter, and if they are not well aligned with social returns, the result can be excessive risk taking, excessively shortsighted behavior, and distorted innovation. For example, while the benefits of many of the financial-engineering innovations of recent years are hard to prove, let alone quantify, the costs associated with them - both economic and social - are apparent and enormous.
Indeed, financial engineering did not create products that would help ordinary citizens manage the simple risk of home ownership - with the consequence that millions have lost their homes, and millions more are likely to do so. Instead, innovation was directed at perfecting the exploitation of those who are less educated, and at circumventing the regulations and accounting standards that were designed to make markets more efficient and stable. As a result, financial markets, which are supposed to manage risk and allocate capital efficiently, created risk and misallocated wildly.
We will soon find out whether we have learned the lessons of this crisis any better than we should have learned the same lessons from previous crises. Regrettably, unless the United States and other advanced industrial countries make much greater progress on financial-sector reforms in 2010 we may find ourselves faced with another opportunity to learn them.