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Thursday, March 26, 2009


commenting at option armageddon

rolfe winkler presents a decidedly different view than what i've settled on at his excellent blog option ARMageddon. i've recently left a (too long) string of comments here and here.

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Great stuff, gm. The Koo link is outstanding.

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Hi gm-

I'm glad to see you diverging more clearly away from the mainstream treasury bear camp... (As should be obvious by now I've always been skeptical of the treasury bear position, given the lessons of history with respect to this kind of crisis).

I think one of the key points people miss with the standard "these deficits are too big to be financed" claims is just how large the scale is of existing assets that are imploding or being absorbed by the government, leaving a big asset-demand "hole" that treasuries can sort of fill (with complications, of course).

Also there is so much ideological hatred of government that can blur thinking. The situation boils down to an investment choice between an entity with the lowest default risk (almost certainly zero for the US, given that it always has the option to print its own currency) and a sea of options (corporates, municipals, etc) with substantially higher default risk in the context of a debt deflation. It may be a rocky road to get there, but in this type of crisis that has no easy solutions, it's my belief that people will increasingly gravitate to "safe" investments. As to long duration versus short duration choices... I believe hunger for yield will over time push people longer out onto the curve even if there are some intermittent fearful flights to the shorter durations.

RolfeWinkler said "...start coming to the conclusion that the only possible outcomes are default or monetization...".

Regarding monetization -- if you believe like Steve Keen and others that the market leads the credit creation/reduction process, monetization is very unlikely to be successful at creating inflation before devleveraging is complete.

Regarding default -- it seems to me that either the belief path that the US will default or the belief path that the US will not can be a self-fulfilling prophecy, and I suspect the latter path will win out given the scarcity of good alternative safe havens. This could mean treasury yields are pushed low enough to be serviceable from tax receipts, even if government debt rises enormously (see Japan, 180% of GDP and low yields). For some reason the treasury bears seem to focus on the former potential self-fulfilling dynamic while ignoring the latter one. It probably has to do with being under the illusion of a "return to normal" in all areas except government debt levels.

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reading koo's book was frankly a revelation, rb, hbl. a stroll through the accumulating data makes plain that we are facing what he describes (though of course with the wrinkles that accompany every differing specific situation). his analysis and framework is, moreover, so compelling that i don't hesitate to say his work on depressions will rank with keynes if not obviate it. it's the roadmap.

this crisis has in many respects been the exemplary death of old-line monetarism -- no one will ever sensibly take friedman at face value again. and i have to agree with this sentiment:

there is so much ideological hatred of government that can blur thinking.

i'm a conservative fellow by nature, but to my mind i see shades of the cartoonish ideological stubbornness of the elites and those who would reflexively support them in the 1920s. (though i should be clear -- i'm not at all talking about rolfe winkler specifically.) conditioning oneself to vomit at the thought of government is neither a philosophy nor an understanding -- it is an escapist fantasy. at the risk of oversimplifying the panoply of risks we face, there are right ways and wrong ways to deal with balance sheet recessions. excluding the use of the government balance sheet in some fashion is, i think obviously, one of the wrong ways.

however -- i do think one can overdo it. japan had massive domestic household savings pool to draw down and a huge export market to draw income from. these were invaluable aids. while i do think financial assets will continue to be sold off to pay down debt and seek the liquidity and safety of treasuries (directly or though banks), there will be no exporting our way out. (of course, that has now become a terrible mixed blessing for japan -- perhaps better for us that we are in no position to seek such 'favorable' imbalances.)

the upshot, though, was never having to go into the international markets to sell JGBs. there is a danger here, however, that government spending -- being too interested in bailing out banks and other financial intermediaries -- will end up trying to sell much more treasury debt than increases in domestic cash flows to banks (savings, debt paydowns) will permit. particularly as banks are the beneficiaries of fat spreads and unmoveable government financing, they ought be allowed to earn their solvency back a la the latam crisis aftermath 1982-95. government balance sheet must be directed at demand management, or the whole house of cards can yet collapse.

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As Koo mentions on slide 20 of the presentation, there is yet the possibility of a dollar collapse due to over-aggressive monetary action. It seems a bit of a roll of a dice though isn't it -- how do you know that fiscal actions were optimal in balancing govt spending with demand for treasuries and did not result in an irreversible loss of faith in the currency? What if a concurrent peak oil scenario is a catalyst for the same? Retail investors like me can now invest in a whole range of commodities.

You seem to point towards a similar collapse scenario yet here too.

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