Friday, March 18, 2011

The Path to Infinite Leverage

Money Supply

MZM: Money with zero maturity. It measures the supply of financial assets redeemable at par on demand.



Let's assume MZM earns a rate similar to 3-month T-Bills.



This is how much interest would be generated using that assumption.



1. In general, when more leverage is applied to anything we can expect more volatility. This chart definitely shows increasing volatility.

2. If history is a guide, then no matter how much the money supply (the MZM part of it) grows it will always tend to generate roughly $136 billion in interest (the median value in red). Fascinating.

3. Note that the $136 billion in interest is not adjusted for inflation. That implies it is becoming harder and harder to make money off of money. That's a theory I've had since 2004. It is also why I am comfortable locking in rates on long-term TIPS.

4. History may be a guide. If so, I think we'd pretty much be following Japan's history.

5. History might not be a guide. Something might break. Stagflation would definitely break it. You'd have high short-term rates and a large money supply. Multiplying them together produces very big numbers. These numbers would be found well off this chart.

6. Look what happens when I add recession bars.




On the one hand, all three of the last recessions were preceded by a spike in this chart. That implies that a recession is not coming anytime soon.

On the other hand, this is the first time we've hit the zero floor and scraped along it as if we were trying to dig through. What if we needed to dig through but couldn't? Then what?

Update:




In order for a median trend to make sense long-term, you need to spend roughly the same time above the line as below the line. The area in blue should roughly equal the area in orange. As seen in the chart, we're generating a lot of orange.

If the plan is to generate orange until unemployment hits 4% then I have just one thing to say. If the 1970s are any indicator, good luck on that one!

Source Data:

St. Louis Fed: MZM Money Stock
St. Louis Fed: 3-Month Treasury Constant Maturity Rate

20 comments:

CP said...

Very cool.

Anonymous said...

"this is the first time we've hit the zero floor and scraped along it as if we were trying to dig through. What if we needed to dig through but couldn't? Then what?"

Well, what would happen?

Stagflationary Mark said...

Anonymous,

"Well, what would happen?"

At the very least, I would expect the recovery to take longer.

I'm not sure what it means to us right now though. One would think that you could make up for hitting a zero floor by simply staying at zero longer.

We've been here quite a while so far. Maybe even too long. The CPI has been heating up as investors make heavily leveraged bets on commodities.

I'll post an update to show another way to look at it.

getyourselfconnected said...

Awesome post!

Mr Slippery said...

Mark,

I am trying to understand implications of MZM x 3mo T-bill rate and the charts.

I think your premise that it is harder to make money from money is only true for the non-financial elites. Everyday savers like us get low rates while primary dealers can borrow from the Fed at 0.25% and buy 30-years bonds at 4.43%. I'd say that is pretty easy money.

The trading desks at the big banks tend to have a near 100% success rate every day. So much for those unpredictable markets.

I need to spend more time considering your post.

Jazzbumpa said...

Mark -

I am in general disagreement with almost all of this post. Re: your points.

1) But MZM is essentially cash and equivalents so the leverage factor is 1.00000000.

2)Except when it doesn't - which is the vast majority of the time. Over the last 20 years, it's almost never been within 10% of that number, and has almost always been more than 30% away from it. And far more than 30% over the last decade.

3) To determine how hard it is to make money off of money, just look at the real interest rate. This has been generally falling for almost 4 years, and has actually gone negative for 5 Yr inflation adjusted securities.

4) Sadly, this is probably right.

5) For stagflation, you need real inflation, not commodity speculation induced bubbles. Wake me when that happens. You'll know when real estate heats up and people are getting cost of living adjustments in their pay envelopes.

6) Recession preceded by short rate increase is the norm. Nothing to see here.

The reason we can't have a recession any time soon is that we will probably never get out of the one we're already in.

When we need to dig through the floor, but can't, we're at the zero bound and in a liquidity trap. Krugman writes about this a lot.

The 70's are not an indicator. Everything is different. See point 5.

The right model is the 30's.

Alas,
JzB

Stagflationary Mark said...

Mr Slippery,

Everyday savers like us get low rates while primary dealers can borrow from the Fed at 0.25% and buy 30-years bonds at 4.43%. I'd say that is pretty easy money.

Anyone who can successfully apply leverage in the right direction can clean up in an overleveraged world.

In that sense, it does take money to make money. You can't apply leverage if you live paycheck to paycheck.

Stagflationary Mark said...

Jazzbumpa,

How can you say that you are in general disagreement with almost all of this post?

1. You agree that it is harder to make money off of money.

2. You agree that we might be sliding into Japan's deflation.

3. You agree that we're at the zero bound and that we might have needed to go lower.

You seem to be caught up on Krugman's bogus theories that commodity inflation will lead to higher employment, because so far that's about the only type of inflation we're getting.

That seems to be where we disagree.

Of course, Krugman can't see commodity speculation. It doesn't support his theories or his political agenda.

The Amazingly Twisted Logic of Paul Krugman

Here's a summary of his opinions as seen above.

1. Quantitative easing will create inflation.
2. Quantitative easing does not lead to higher commodity prices.


You say:

"The 70's are not an indicator. Everything is different. See point 5.

The right model is the 30's."

That's your opinion. It is and has been my opinion that we are trying to combine the 1930s and the 1970s. It is not an either/or situation here. Combining the deflationary 1930s and inflationary 1970s would give us a tame CPI and high unemployment. That's exactly what we are seeing.

Mr Slippery said...

It is and has been my opinion that we are trying to combine the 1930s and the 1970s.

Ah, the greatest hits of central bank errors. I can buy into that. Take everything they haven't learned over the last 100 years and apply directly to forehead. Unfortunately, no fast, effective relief.

Stagflationary Mark said...

I would also point out that you took my 1970s opinion out of context. I included two "ifs".

"If the plan is to generate orange until unemployment hits 4% then I have just one thing to say. If the 1970s are any indicator, good luck on that one!"

I stand by that claim. I do not believe that continued commodity speculation will be consistent with 4% unemployment. We did not see it in the 1970s and we won't see it now.

Stagflationary Mark said...

Mr Slippery,

I cringe at the thought of what will happen if the 1930s and 1970s are truly combined.

Let's say you add deflation and inflation to get tame inflation overall.

What happens if we add the high unemployment of the 1930s to the unemployment of the 1970s? We're not there yet obviously.

How could it happen? Picture $300 oil. Not saying we will get there but it is an interesting thought experiment.

Put another way, if we enter the next recession with already high unemployment then just how high could unemployment go?

Fed deems several major banks healthy enough to pay dividends

The Fed examined what would happen to the banks’ finances if unemployment rose to 11 percent by the end of this year, up from 8.9 percent last month.

Since when has the Fed ever determined a proper worst-case scenario? If we enter another recession with high unemployment then 11% would simply be a starting point.

Mr Slippery said...

UE is clearly above 8.9% if you count the people who have given up and the people working part time that want to work full time. Above 11% already, too.

Worst case is not even $300 oil. OK, that's close. I picture worst case as $300 oil, $4 trillion deficit and 17% U-3. Hopefully, I am way too pessimistic.

Stagflationary Mark said...

Mr Slippery,

The deflationary worst-case is that $100 oil is already the crack in the dam. We just don't know it yet.

In theory, we'd still get to keep your $4 trillion deficit and 17% U-3 theories perhaps. We'd just call them deflationary instead of stagflationary.

Woohoo! Sigh.

Stagflationary Mark said...

One more thought before I head off to do other things.

I think this posts shows how torn I am between the arguments of the deflationists and the arguments of the inflationists.

I'm somewhere in the middle ground.

If I knew what would happen I'd be joining the rush to either heavily invest in commodities or heavily short them. I'm not!

TIPS are a very wimpy middle ground bet.

Stagflationary Mark said...

"If the plan is to generate orange until unemployment hits 4% then I have just one thing to say. If the 1970s are any indicator, good luck on that one!"

I've been giving my quote some more thought.

I'm heckling those who think that it should be the plan (like Krugman for example). I'm not trying to suggest that it is the plan. I have no idea what the Fed intends to do next. I don't think that it is a given that they want even higher oil prices from here.

1. There are those who think deflation is bad. Debts are extremely hard to pay if you are experiencing wage deflation.

2a. There are those who think that inflation will help. If wage inflation appears, then people would earn more money and debts will be easier to pay.

2b. There are those who think that inflation will hurt. If commodity inflation appears and it is much greater than wage inflation, then debts will be harder to pay.

I'm a believer in all three camps. Unfortunately camp 2a is losing the battle. Had the inflation been spread evenly between wage inflation and commodity inflation then I would believe in 2a. That's not how the real world works though.

If you want me to change my opinion then you'll need to show me some hedge fund "wage inflation" speculators. I don't see any/many.

Stagflationary Mark said...

One more thought.

When investors lose money in short-term savings then they are EXTREMELY likely to turn to commodity speculation and hoarding. I certainly did in 2004. It was the reason I bought gold and silver that year (no longer own either). I had never done that before. It was a first.

There's roughly $10 trillion sitting in MZM earning next to nothing right now. My online savings account pays just 1.0%.

This is the same mechanism of the 1970s. Real interest rates were negative for much of the decade.

We also have the same mechanism of the 1930s. We borrowed too much individually. Way too much.

Two wrongs aren't going to make a right.

As an added point of despair, we also have a $10 trillion cumulative trade deficit (each quarter adjusted for inflation and summed). That wasn't common to either era and will continue to create economic pain in the future.

getyourselfconnected said...

The Krugmonster is my nemesis.

Jazzbumpa said...

Mark -

Of your six numbered points, I disagreed with 4, agreed with 1, and disregarded 1. That's sort of general disagreement in my book.

Aside from missing Krugman's sarcasm, you misrepresent him at your link, and you are misrepresenting me. I don't believe he has ever said that commodity inflation will lead to higher employment, and I certainly do not believe such nonsense.

Hence PK's continuing emphasis on core rather than headline inflation.

Cheers!
JzB

Stagflationary Mark said...

Jazzbumpa,

"1) But MZM is essentially cash and equivalents so the leverage factor is 1.00000000."

I said, "1. In general, when more leverage is applied to anything we can expect more volatility. This chart definitely shows increasing volatility."

Since MZM has grown exponentially, the swings in interest generated have also grown exponentially. Picture $1 trillion interest if short-term rates hit 10%. Now picture what interest rates would have been in 1982 to generate $1 trillion in interest. Try 100%. That's 10x. In other words, a 1% change in interest rates now (either up or down) is far more effective at altering our economy than it was in 1982. That's what I mean here when I'm talking about leverage.

It's like the difference between riding a seesaw with a skinny kid and riding one with Fat Albert. The heavier the person on the other end the more you should fear the leverage of the seesaw. $10 trillion in MZM makes Fat Albert look skinny by comparison.

I don't have the time today to go through them all one by one. I guess we'll just have to agree to disagree. We seem to disagree on quite a bit these days. Most seem to be based on our wildly differing opinions of Krugman and his theories.

Life is full of differing opinions though. I do appreciate the conversation. Nobody learns anything by listening only to "yes men".

As a side note, I'm not a fan of either the Republican agenda or the Democrat agenda. I feel that both sides bend the economics to fit their needs. I'm just looking for the truth as best I can.

And lastly...

"Aside from missing Krugman's sarcasm, you misrepresent him at your link, and you are misrepresenting me. I don't believe he has ever said that commodity inflation will lead to higher employment, and I certainly do not believe such nonsense."

I never claimed that Krugman said that commodity inflation will lead to higher employment. You might want to reread what I wrote. My actual claim is that Krugman won't even acknowledge that commodity inflation is an unintended consequence of his theories.

CP said...

"hedge fund 'wage inflation' speculators."

Genius!